Although the uncertainties about Dr. Rajan’s exit persist, the monetary policy stance remains as crystal clear. On the back of higher than expected inflation in April and reluctance of banks in passing on the benefits of previous rate cuts, markets expected RBI to maintain the status quo on policy rates. In line with expectations, the Central Bank held rates unchanged.

Background to the second bi-monthly monetary policy
The Global growth has been uneven since the in first bi-monthly monetary policy statement released in April 2016. Growth in the U.S. and China slowed, while that in the Europe strongly recovered thanks to higher consumer spending, recovery in the job market, and improved business conditions. That being said, overall trade volumes remained low across the globe. Financial markets recovered considerably as the risk appetite re-emerged. Crude prices firmed up, and other commodity prices showed resilience too. Capital flows started slowly returning to emerging markets. Bond yields in the advanced economies eased pointing at the robustness of the primary issuances. US$ remained strong so as Yen Euro.

Back home, leading macroeconomic indicators remained encouraging. Cargo traffic at India’s major ports increased. Cement production and steel consumption jumped, and automobile sales climbed higher. Capacity utilisation and order book positions at factories are improving. Air and freight traffic also improved notably. Leading indicators are often used to predict where the economy is headed. On the other hand, lagging indicators such as corporate profits have also shown improvement. India Inc. has reported a double-digit growth in Q4 FY 2015-16 earnings. India’s GDP grew at 7.9% in Q4, FY 2015-16. Retail inflation remained a cause of concern as food prices witnessed an unusual surge in April 2016. As against the food inflation of 5.11% a year ago, food inflation in April 2016 jumped to 6.32%.

Liquidity situation tightened in May on account of unprecedented demand for currency and cash built-up on the balance sheet of the Government. Despite this weighted average call, money rates revolved around repo rates. The RBI injected liquidity into the system through variable rate repos, in access of that infused through regular operations.

Monetary policy action at glance

• RBI kept the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.5 per cent;
• The Central Bank held the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liabilities (NDTL)
• It also continued to provide liquidity as required but progressively lowered the average predicted liquidity deficit in the system from one per cent of NDTL to a position closer to neutrality

Why the RBI took a pause this time?
Although the RBI didn’t lower policy rates, this time, the policy stance of the Central Bank remains accommodative. In other words, it is still in favour of lowering rates as and when other factors provide room. As per the assessment of RBI, there isn’t any elbowroom to lower rates at this juncture.

The Central Bank has set an objective of anchoring the inflation at 5.0% by the end of March 2017. However, looking at the unexpected jump in food prices, even after considering the seasonal factors, has been worrying.

The impact of factors such as firming up of crude oil and other commodity prices and that of the implementation of the 7th pay commission is yet to be factored in the projection of inflation. The RBI has decided to keep rates unchanged seeing the above factors as upside risks.
  Is food price inflation a threat?

(Source: MOSPI, PersonalFN Research)
Lack of monetary transmission through the banking channel remains a work in progress. The RBI has been insisting banks time and again to lower their base rates in sync with the reduction in the policy rates.

How markets have reacted?
The sentiment in the equity market has been blissful as indices have been trending upwards since the policy announcement came forth. The RBI retained its GDP outlook at 7.6% and sighted recovery in growth, as well as reiterated its commitment to providing short-term Rupee liquidity as and when needed; bond markets, the bond yields remained steady too.

Outlook...
Going forward, the RBI’s stance on monetary policy may remain accommodative provided inflation does not rear its head again. A strong monsoon, continued astute food management, as well as steady expansion in supply capacity, especially in services, remain crucial for further rate cuts. Monetary policy transmission, credit flows, and capital infusion into the banks among others are the factors that will continue to affect the policy decision even in future.

Beyond Monetary Policy Review...

• Although RBI avoided slashing the policy rates further, it touched upon many crucial aspects. The Central Bank hinted at the timely review of the newly introduced Marginal Cost of Funds based Lending Rate (MCLR).It wants to check the efficiency of MCLR regime in monetary transmission. The RBI opines that higher deposit growth and paucity experienced in the credit growth will eventually lead banks to cut base rates to attract new borrowers. This in effect will result in higher monetary transmission.
• On the back of global uncertainties that prevail, RBI remained confident about the fundamentals of the Indian economy. It believes, India has right policies in place and has more long term liabilities besides having reasonably high forex reserves.
• RBI also clarified that it had no inclination to lead Rupee in any direction. Rather it will intervene only to curb the volatility.
• RBI avoided any time commitment on erasing the long-term liquidity deficit in the system. Rather it hinted at taking an opportunistic approach to long-term cash management.

Key takeaways for investors and borrowers
RBI has sent a clear message to banks—lower the base rates or forget about further policy rate cuts. At the same time, the message for the Government is this—take out supply side bottlenecks that create inflationary pressures or don’t expect the Central Bank to lower the policy rates. This indicates that banks may reduce lending rates in coming quarters, and the Government may also take prudent measures to eliminate the bottlenecks. Good monsoon may provide more space to the RBI for further policy actions.

in PersonalFN is of the view that, you should not take any investment decision based on the speculation about the direction of the monetary policy. You should focus on your long-term financial goals and chalk out personalized asset allocation. While in investing in mutual funds, you should do thorough research and choose funds with a dependable long-term track record. While investing in debt funds, you should not invest more than 20% of your fixed income portfolio in in long-term debt funds.
 

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