At the sixth and final bi-monthly monetary policy review of the Financial Year (FY) 2016-17, the RBI surprised trackers of the policy action by holding rates unchanged at 6.25%. The reverse repo rate under the Liquidity Adjustment Facility (LAF) also remains unchanged at 5.75%. And the marginal standing facility (MSF) rate and the Bank Rate stayed at 6.75% as well.

The RBI moved its monetary policy stance from ‘accommodative’ to ‘neutral’.

It seems its policy approach has clearly shifted from being largely reactive to being more proactive.

And there are reasons to believe so…

In the run up to this policy review, the big event of the Union Budget 2017-18 was out of its way, and the Government had hinted at honouring the target of 3% on fiscal deficit, recommended by the FRBM Review Committee for the next 3 years. Retail inflation for Q3, FY 2016-17 averaged at 3.8% while for the first 9 months of FY 2016-17 averaged 4.9%. On the other hand, the food inflation stayed at 2.2% on an average in Q3, FY2016-17 while that for the period between April-December it averaged 5.2%. The Economic Survey 2016-17 had also shown confidence in RBI’s ability to contain inflation at 5.0% by the end of FY 2016-17.

On this backdrop, many economists and capital market participants were hoping for a 25bps (Basis Points) rate cut. Although a few had expected the RBI to maintain status quo taking a conservative step, no one might have guessed that it would change its stance to ‘neutral’.

Moreover, the 6-member Monetary Policy Committee has unanimously voted for the policy decisions.

What made RBI take this decision?

The RBI has given itself a full flexibility to deal with future uncertainties by changing the policy orientation. Justifying its move the RBI Monetary Policy Statement stated that, “The committee decided to change the stance from accommodative to neutral while keeping the policy rate on hold to assess how the transitory effects of demonetisation on inflation and the output gap play out.”

Demonetisation has left the banking system with an overhang of liquidity. MPC believes, the amount of liquidity in the system may allow a greater policy transmission.

But that’s not all. The action goes much beyond demonetisation.

Here’re some other factors RBI has cited to base its case of going ‘neutral.
 

• Global recovery has been driving up the inflation expectations globally mainly on account of rising energy prices
• Anticipated exchange rate volatility, owing to global uncertainties
• Sticky nature of core (non-food, non-energy) retail inflation back home

RBI expects Indian economy to grow at 6.9% in the current fiscal. However, the Central  Bank hopes for a speedy recovery in FY 2017-18 largely on account of the following reasons:
 

• Rebounding of consumption led to demand in the economy to pre-demonetisation level, sooner rather than later
• Cash-dominated sectors such as retailing, transportation, hotels and restaurants returning to normalcy
• Cooling off  lending rates for deserving borrowers, which may help in reviving the capex cycle in the private sector
• Higher Government expenditure on infrastructure, rural development, and affordable housing

What RBI expects?

It expects the Indian economy to grow at 7.4% in FY 2017-18.

Further, the RBI remains hopeful that, “The environment for timely transmission of policy rates to banks lending rates will be considerably improved if (i) the banking sector’s non-performing assets (NPAs) are resolved more quickly and efficiently; (ii) recapitalisation of the banking sector is hastened; and, (iii) the formula for adjustments in the interest rates on small savings schemes to changes in yields on government securities of corresponding maturity is fully implemented.”

However, the MPC has been of the view that, “The persistence of inflation excluding food and fuel could set a floor on further downward movements in headline inflation and trigger second-order effects. Nevertheless, headline CPI inflation in Q4 of 2016-17 is likely to be below 5 per cent. Favourable base effects and lagged effects of demand compression may mute headline inflation in Q1 of 2017-18. Thereafter, it is expected to pick up momentum, especially as growth picks up and the output gap narrows. Moreover, base effects will reverse and turn adverse during Q3 and Q4 of 2017-18. Accordingly, inflation is projected in the range of 4.0 to 4.5 per cent in the first half of the financial year and in the range of 4.5 to 5.0 per cent in the second half with risks evenly balanced around this projected path.”

Impact of the policy action on the common man

With the shift in RBI’s stance, we might be approaching the end of the policy rate easing cycle. In other words, unless there is a risk of it missing the medium term inflation target of 4.0% by a substantial margin, it is quite unlikely that the RBI will lower policy rates in the foreseeable future. This implies that to attract new and healthy borrowers, the banks and other financial institutions will have to set their lending rates prudently, to allow larger monetary policy transmission.

Depending on the liquidity situation, banks will have to rationalise deposit and lending rates further. RBI’s vigil on curbing inflation may help in dealing with wild price swings.

Impact on investors

Soon after the RBI announced its monetary policy review, both equity and bond markets reacted negatively while INR movement was positive against the US$. PersonalFN believes, the unpreparedness of the markets to accept the change in the stance of RBI prompted the adverse reaction. Precisely for this reason, PersonalFN discourages its readers and investors from speculating on the direction of markets or even on the particular macroeconomic events.

PersonalFN is of the view that you should revisit your financial plan and take this opportunity to realign the portfolio to your financial goals and risk appetite.

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