RBI Gifts the Market the much hoped 25 bps rate cut

It’s a new era at the Reserve Bank of India (RBI), where the monetary policy decisions are made collectively for the first time. With no history to rely on, economists have been split on the outcome. But against the expectations of the experts, the king has given the market what it was hoping for. The falling inflation gave Urjit Patel and the Monetary Policy Committee the room it needed to do the rate cuts.

The gift:

• The committee has decided to slash the policy repo rate under the Liquidity Adjustment Facility by 25 bps. The repo rate now stands at 6.25% against the previous 6.50% with the immediate effect.
• The reverse repo rate is adjusted to 5.75% under the LAF
• The Marginal Standing Facility and the Bank rate stand at 6.75% as compared to the previous 7%.
• Inflation target aimed at 5.3% for Q4 while there is no mention of CRR in the policy.
• With the cut in Repo rate, interest on consumer loans is expected to fall.

The decision of the MPC is consistent with an accommodative position of monetary policy in consonance with the objective of achieving consumer price index (CPI) inflation at 5 percent by the fourth quarter of 2016-17 and the medium-term target of 4 per cent within a band of +/- 2 percent while supporting growth.

The Considerations:

Global growth has been decelerating more than projected through 2016 so far. Weak investment and trade have been damping aggregate demand. The risks in the form of Brexit, banking stress in Europe, rebalancing of debt-fuelled growth in China, rising protectionism and diminishing confidence in monetary policy have skewed the outlook to the downside.

International financial markets were besieged by the Brexit vote in the second quarter, with equity markets losing valuations worldwide, currencies plummeting and turning volatile, and investors rushing for safe havens. Markets, nevertheless, recovered quickly and reclaimed lost ground in the third Quarter, with a return of risk-craving propelling capital flows back into EMEs. Crude prices rose to a fresh high in the second Quarter of 2016, mostly on supply disruption in various parts of the world, and as the OPEC announced intentions of cutting back on supply again in late September; but, the upturn has been curbed by higher inventories.

On the domestic front, the position for agricultural activity has brightened considerably. The south-west monsoon ended the season with a cumulative deficit of only 3 percent below the long period average, with 85 percent of the country’s geographical area having received normal to excess rainfall.

The industrial sector, however, suffered a manufacturing-driven retrenchment in the second quarter of the early financial year, after a sequential deceleration in gross value added in Q1. In August, steel production increased to a 37-month high and cement production maintained momentum, in spite of the production of core industries as a whole was pushed down by a decline in the production of coal, crude oil and natural gas and deceleration in refinery products and electricity generation. The strong public investment in roads, railways and inland waterways, the of late efforts to release cash flows in large projects under arbitration, and the boost to spending from the 7th Pay Commission’s award, should improve the industrial outlook.

In the services sector, the hastening in the pace of activity in the first Quarter appears to have been persistent. A growing number of high-frequency indicators are moving into positive territory, construction is boosted by policy initiatives, and public administration, defense, and other services will be supported by the pay commission award.

CPI had been raised by a sharp pick-up in the momentum of food inflation overpowering favorable base effects during April-July. In August, however, the impetus of food inflation turned negative and surprised expectations. Fuel inflation has modified steadily through the year so far. Inflation excluding food and fuel has been sticky around 5 per cent, mainly in respect to education, medical and personal care services. Households reacted to the recent rising of food inflation adaptively and hardened their inflation expectations.

Liquidity conditions have remained comfortable in the third Quarter, with the Reserve Bank absorbing liquidity on a net basis through variable rate reverse repo auctions of different tenors. Liquidity was injected through open market purchases of `200 billion in lines with the system’s requirements. As a result, the weighted average call money rate, i.e.,.WACR remained tightly aligned with the policy repo rate and, in fact, traded with a soft bias. Interest rates on commercial paper (CPs) and certificates of deposit (CD) also eased.

Governor Speaks:

Urjit Patel addressed the media after gifting the market the much-hoped rate cut. He said that for the first time in a long time, weak global demand is going to pull down the trade volume. IMF may further downgrade global growth and that he will be surprised if it doesn’t happen. He also stated that the MPC members would enhance process and quality of policy making.

Dr. Patel suggested that everyone must be vigilant against the emergence of cost-push pressures and that they will continue to move towards neutral liquidity. There will be no change in stance.

He also added that the growth in EU remains uncertain, also face overhang of US elections. He will watch out for the outcome of US Presidential elections.

The Governor declared that the discussions of MPC were frank, often intense and friendly. The easy liquidity conditions generated by the Reserve Bank’s operations should also enable the swift transmission of the policy action through various market segments. Furthermore, Banks should find added momentum for better transmission by the recent downward adjustment in small savings rates. RBI allows startups to raise up to $3 mn/year from overseas market.

Market Reacts:

At 2.30 pm, the rupee was trading at 66.41, up 0.27% from its previous close of 66.58. The 10-year benchmark bond yield was trading at 6.778% compared to its previous close of 6.773%. India’s benchmark Sensex rose 0.52% to 28,390.66 points and Nifty hiked by 0.36% to 8,769.15. Bank Nifty was trading with the rise of 0.43% witnessing the most fluctuation during the unveiling of the Credit Policy rising to trade at 19,717.90 against its opening of 19,589.05.

Concluding:

The RBI has discovered policy space to actively support growth in the Indian economy by a 25 basis point reduction in the repo rate. The last downward revision happened in April 2016 when the repo rate was cut from 6.75% to 6.50%. Both the repo rate reduction and comfortable liquidity conditions should guide to a tangible increase in credit growth, thereby improving growth prospects in the second quarter of FY17. World-wide sense is that neutral rates are going down. Need to take into account global situation for determining the neutral rate.

A writer by day and a passionate reader by night. Writing just doesn't fill my pocket but it also fills my heart. Passion for writing about new events & happenings is what soothes my mind & soul.