Focus on liquidity alongside easing: The RBI cut its key repo rate by 25bps and maintained an accommodative bias as expected (despite signaling upside risks to inflation), but surprised positively by making important changes to its liquidity management operations (narrows interest rate corridor to 100bps from 200bps earlier, changes liquidity stance to ‘neutral’ from ‘deficit’ earlier). We expect the net impact of the announcement to extend the rally in bonds (especially in the belly of the curve) and to lower the potential floor for ND-OIS rates in this cycle. We expect the medium-term impact on the currency to be limited; rupee is likely to be influenced more by external developments and RBI’s FX reserve accumulation.
Lowering FY17 CPI forecast on pay commission delay; see another 25bps easing in FY17: We revise down our avg. FY17 CPI forecast from 5.3% earlier to 4.9% on account of a likely delay in the implementation of 7th pay commission (PC) (June’16 vs April’16 in our earlier projection) and lower service tax hike (15% vs 16%) in the budget. The moderate hike in MSP (as imputed from food subsidy for FY17) and normal monsoon conditions reinforce our view of another year of benign food inflation. We also expect CPI inflation to undershoot RBI’s 5% projection in the January-March17 quarter.
New liquidity management framework to reduce tightness: Banks have been allowed a greater leeway in cash reserve maintenance, an easing of liquidity conditions is promised, while the rates on RBI’s various liquidity facilities have been tightened around the repo rate.
How much OMO can happen?: If the RBI makes the liquidity deficit neutral by providing the entire 1% of NDTL over 1 year, the monthly durable liquidity provision could be about `80bn. Given our estimate of BoP surplus of $30bn in FY17, per month purchase of domestic assets (OMO) could be in the range of `60 – 100bn (vs `43bn per month in FY16).