For the first time in the history of RBI, Monetary Policy Committee (MPC) took a decision on policy rates at the third bi-monthly policy review meet held on October 03, 2016. A panel of 6 members reached a consensus, without any contrary view, to lower repo rates by 25bps (basis points). MPC's policy action seems to have hit many experts and market participants like a ton of bricks. By and large, economists and expert commentators were expecting RBI to maintain the status quo, citing the upside risks to inflation. Surprisingly, the central bank slashed the repo rate to 6.25%--a 6-year low.

Background to the third bi-monthly monetary policy

Over last 2 quarters, global growth has been stunted under the pressure, and trade volumes have declined considerably, posing a further downside risk to the growth. Industrial activities in advanced economies have substantially weakened, giving rise to protectionism in some developed world economies, threating to diminish trade volumes. Despite rising crude oil prices, inflation in the advanced economies remains benign, and the emerging markets have begun to cool off.

Speaking about the domestic economy, a healthy monsoon this year has significantly boosted agricultural activities. Except for the Sugarcane, Jute, and Mesta, this season the sowing has been higher than last year's acreage. As per the primary Advance Estimate of Kharif foodgrains, production for 2016-17 is likely to be 11.02 million tonnes higher (at 135.03 million tonnes) than the last year's Kharif foodgrains production of 124.01 million tonnes. Among all important categories, rice, maize, and pulses are likely to see a record-high production this season, which may raise the overall food grain production to a new high as well. In contrast, industrial and manufacturing activities witnessed a lull in Q2, reflecting in the Index of Industrial Production (IIP) numbers. Having said that, RBI's industrial outlook survey suggests that the expansion projections/expectations of corporations have remained positive for Q2 and Q3.

On the inflation front, food price inflation was much higher than anticipated, even after considering the seasonality, in the Q1 FY 2016-17. Besides this, firming up of crude oil prices and effects of low base effects made the situation worse. Understandably, households pegged their estimates of retail inflation higher. Nonetheless, good monsoon and measures taken by the Government to correct the supply-channel constraints throttled the momentum of inflation.

 

Inflation drops sharply…

(Source: MOSPI, PersonalFN Research)
As a result, headline retail inflation, as measured by the movement of Consumer Price Index, averaged at 5.7% in Q1 of Fy 2016-17, as against the forecast of 5.3%. As revealed by the RBI's Monetary Policy Report, October 2016, "A one percentage point deviation of food inflation from its trajectory projected in the April MPR leads to 47 basis points increase in headline inflation in terms of the direct effect alone and this perturbation could cause headline inflation to diverge from its projected path for upto four to six months."

As far as the performance of the external sector goes, India's export contracted in July and August, however, during the same time, imports fell at a faster than expected rate, dragging the trade deficit. Between April 2016 and August 2016, India's trade deficit shrank by US$ 10 billion on a year-on-year basis.

Liquidity situation eased considerably over last few months as, through various Open Market Operations (OMOs), RBI introduced liquidity worth Rs 20,000 crore into the system. To do the balancing act, RBI sucked out excess liquidity through variable reverse repo auctions. Nonetheless, it has reaffirmed its commitment to erasing the durable liquidity deficit and achieve the neutral liquidity position.

On this backdrop, RBI's monetary policy stance continued to be accommodative.

Monetary policy action at glance

• RBI reduce the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 6.5 per cent to 6.25 per cent with immediate effect.
• Consequently, the reverse repo rate under the LAF stands adjusted to 5.75 per cent, and the marginal standing facility (MSF) rate and the Bank Rate to 6.75 per cent.

The RBI has set a target of 5.0% retail inflation by March 2017, while it's medium term target remains unchanged at 4.0% with a 2% margin of error on either sides.

The RBI 's rationale behind lower rates

Out of 37 economists surveyed by Bloomberg, 20 expected RBI to hold rates unchanged. However, contrary to the expectation of the majority, RBI slashed the repo rates.

The MPC believes the pickup in agricultural output and estimated food grains production which is likely to be at the record high, would improve the outlook for food inflation. Also, measures taken by the Government to curb the supply side shocks may help to slow the inflation momentum. Easy liquidity conditions, a downward revision of the interest rates on Small Savings Schemes (SSS) and the adoption of MCLR (Marginal Cost of Lending Rates) regime is likely to facilitate further policy transmission through banking channels. This assessment leads RBI to become more accommodative and lower the policy rates.

However, it is noteworthy that, MPC took into consideration the possible cost push pressures that may emerge, including the effects of the implementation of the 7th pay commission on house rent allowances, and the increase in minimum wages with potential spillovers through minimum support prices, while lowering the policy rate.

How markets have reacted?

Hoping against hope, capital markets anticipated the MPC to debut with a rate cut of 25bps. In the run up to the 3-rd bi-monthly monetary policy review, markets had factored in a 25bps rate cut. As the policy statement cited some upside risks as well, markets remained neutral even after receiving what they wanted. Bond yields dropped only moderately, and the stock markets remained unimpressed as well. .

Should consumers cheer?

Keeping in mind the forthcoming festive season, banks might allow greater policy transmission this time, as that will help them achieve higher credit growth, on the back of the potential pick-up in the credit demand. You may expect new loans to become cheaper and as far as interest rates on the deposits are concerned, they might go further down.

Outlook...

The RBI remained optimistic about the growth prospects of Indian economy and has quoted that, "The momentum of growth is expected to quicken with a normal monsoon raising agricultural growth and rural demand, as well as by the stimulus to the urban consumption spending from the pay commission's award. The accommodative stance of monetary policy and comfortable liquidity conditions should support a revival of credit to the productive sectors."

Providing guidance on inflation, RBI maintained caution saying, "The Committee envisages a trajectory taking headline CPI inflation towards a central tendency of 5 per cent by March 2017, with risks tilted to the upside albeit lower than in the second and third bi-monthly monetary policy statements of June and August respectively."

Speaking about the medium-term outlook, the RBI also stated that, "The inflation outlook for 2016-17 has improved, but beyond, close vigilance is required to achieve the prospects of reaching 4 per cent i.e., the centre of the target band. Robust consumption brightens the outlook for real gross value added (GVA) in 2016-17, but muted private investment and weak global demand may restrain the pace of growth in 2017-18."

PersonalFN is of the view that, although RBI has lowered the policy rates for now, the outlook remains cautiously optimistic. The RBI has also shown its openness to hike policy rates if needed. This has been keeping market participants guessing the MPC's approach to future policy actions. The RBI has also recognised the need to deal with the bad assets issue of the banking system firmly and in a more pragmatic manner.

What investors should do?

Markets have cheered the unexpected rate cut. The 10-yr 7.59% 2026 G-Sec benchmark yield has fallen nearly 10 basis points (bps) to around 6.82% since the end of September. On the expectations of a rate cut by some quarters of the market, a rally has already been captured at the longer end of the yield curve and further steam seems to have lost. Therefore, don't go overboard while investing at the longer end; refrain from investing more than 20% of your allocation in debt funds We suggest, consider dynamic bond (as they are enabled by their investment mandate to take positions across maturity profile of debt papers) while taking exposure at the longer end, provided you have an investment horizon of at least 3 years.

In case you have a time horizon of less than a year, stay away from funds with longer maturities. If you have a short-term investment horizon of 3 to 6 months, you could consider investing in ultra-short term funds (also known as liquid plus funds). And if you have an extreme short-term time horizon (of less than 3 months) you would be better-off investing in liquid funds.

Don't forget that investing in debt funds is not risk-free. Therefore consider the 5-facets while investing in debt funds.

Investors in equity should pay close attention to valuations as they appear expensive at the moment. Under such circumstances, where margin of safety has reduced, investors should prefer investing in a staggered manner. Systematic Investment Plans (SIPs) would be ideal at this juncture. While buying into mutual funds, select wisely and prefer diversified equity funds which follow strong investment processes and systems. One needs to have long-term investment horizon in mind, of at least 5 years. PersonalFN believes that your investment discipline and asset allocation would decide your success in investing. Therefore, continue to invest in equity if your risk appetite and asset allocation permits, but adopt a sensible approach.

Beyond Monetary Policy Review...

The press conference that followed the third bi-monthly monetary policy review meeting ended quicker than usual, as the new RBI Governor requested to wrap up the conference as soon as 15 minutes elapsed. This took many participants by surprise. Whether this is strictness or a new norm, only time can tell. Another aspect that is being widely discussed is the consensus of all MPC members. Three members of the 6-member committee represent the Government. RBI and the Government have often taken a contrary view about the policy rates on many occasions. But, at the debut, the committee struck the concurrence. How this new tryst shapes up going forward will be worth tracking.

All said and done, RBI has announced a Diwali bonus, now it remains to be seen who benefits from this—consumers, investors, corporates or all?

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