Economic Spotlight: RBI Monetary Policy Preview

RBI To Maintain Status Quo The Reserve Bank of India (RBI) will release its first bi-monthly policy statement for the year 2017-18 on April 06, 2017. The announcement about the benchmark repo rate, SLR and CRR will be made public at 14.30 IST and a press conference will follow. We expect RBI to maintain its status quo on the rates as well as its’ “neutral stance”. Short end of the yield curve could steepen if RBI introduces tools to effectively manage prolonged excess liquidity. In the last policy review on February 08, RBI maintained a status quo and kept its policy repo rate unchanged at 6.25 per cent citing its objective of achieving 5 per cent inflation in Q4 2016-17 and the medium-term target of 4 per cent (band of +/-2) while supporting growth. However, what surprised the markets was the change of the stance from accommodative to neutral. In its assessment, the central bank had identified 3 potential risks to inflation - global volatility, hardening crude oil prices and effects of increase in house rent allowances under the 7th Central Pay Commission (CPC). Favorable Base Effect To Wade Off From Inflation Headline inflation for February 2017 came in at 3.65% (y-o-y) and core inflation at 4.8% (y-o-y). Oil prices (Indian oil basket) have significantly declined since the last RBI Monetary Policy meet from $54.86/barrel in February to $49.50/barrel in March. Though, lower oil prices will provide comfort to both headline and through second round effects to core inflation, favorable base effects will wade off in coming months and may push the inflation higher. We estimate that headline inflation for FY18 to be around 4.5-4.6% range. RBI Intervention in Liquidity Management To Watch Out For Post demonetization, RBI has been struggling with excess liquidity in the system. Liquidity management is one of the key pillars through which monetary policy operates. Even after the shift in stance to neutral, call rates have been trading below repo rate making the monetary policy ineffective. In the coming policy meeting, all eyes will be focused on RBI’s ability to think of an out of the box tool like Standing Deposit Facility (SDF) to manage the excess liquidity. SDF was a tool suggested in the Urjit Patel Report in 2014 which allows central bank to withdraw liquidity without having to post collateral. Rupee Appreciation- Will RBI Intervene? Rupee too has been strengthening both in nominal and real effective terms even in comparison to emerging economies. Post prudent budget, advanced GDP estimates, UP Elections INR rally gained momentum. Surge in FII and FDI flows further strengthened INR. We feel that INR is overheated. For RBI to intervene, sucking out the excess liquidity is a perquisite. RBI in its press conference will be liable to answer questions in regards to rupee appreciation and intervention in FX markets. Potential Risks Below normal monsoon as indicated by the initial estimates of private weather forecaster Skymet pose as a potential risk to inflation. Also, aggressive rate hikes by the Fed in US will lower the interest rate differential and may further reduce the room for rate cuts. Outlook We expect RBI to maintain its status quo. The focus will be on the liquidity management framework and target for inflation for FY18. Introduction of any tool to suck in liquidity and FX market intervention could negatively impact the bond markets- short end of the curve could steepen.