The monetary policy review for June was status quo on rates and stance but with 2 dissents now, with external member Dr. Goyal joining Prof. Varma in arguing for both a rate cut and change in stance to neutral. The tone of the Governor and the policy statement continued to be pretty standard, noting 2 way risks to inflation while nudging current financial year growth expectation up a shade. An interesting development is RBI unveiling aspiration goals for RBI@100. Two direct set of goals to track for the future here: 1> Monetary Policy and Liquidity Management, and 2> Capital Account Liberalization and Internationalization of the Indian Rupee
Assessing RBI
In our view the framework to assess RBI has to be anchored in the assumption that it is a conventional inflation targeting central bank. This is important to appreciate since while inflation is above target with some volatility in components, and growth is holding, one should not expect outright dovish commentary from the central bank. Thus, the concerns on 2 way risk on inflation etc are par for the course and do not constitute any incremental signaling. It is also to be noted that a change in commentary / stance will not wait for the actual 4% target to get achieved but rather the path way to that being clearer with component volatility (currently food inflation) subsiding. Additionally, the burden of proof required to assess extent to which component volatility is subsiding may get lowered should growth momentum start to come off. Since this isn’t the case currently the commentary remains single variable focused; that is inflation.
That said it is well understood that the level of GDP is still lower than where it would be if pandemic hadn’t happened. This was also referred to by Deputy Governor Patra in the press conference in response to a question on whether we are overheating. This perspective is important when assessing how much of a growth slowdown may be sufficient for RBI to start to turn, or whether continued 7% plus growth will take out prospects of rate cuts altogether. The answers in our view: 1> not much of a slowdown required for RBI to turn 2> the central bank can very well start cutting even at 7% plus growth if it sees inflation dynamics as being stable since there is still lost growth to be recovered.
Finally, it is worth taking note of again that the entire rate hike cycle was conducted in an environment of heavily surplus liquidity. The liquidity framework had moved away from the quantum of system liquidity (defined as % of net demand and time liabilities of banks) targeted in previous regimes, to anchoring overnight rate at policy rate level using variable rate operations as the primary tool. The focus on liquidity late last year came, in our view, to accelerate transmission to bank lending rates of previous policy hikes. This runs via higher rates on the liability side and, in absence of further rate hikes, relies on more stringent liquidity management by the central bank. Presumably, there has been concern with the pace of credit growth relative to growth of other nominal variables of the economy. Specific concern has been in relation to certain pockets of lending where direct detriments through macro-prudential tools were subsequently placed as well. Lately, there is evidence that credit growth in these pockets is slowing. Should this continue, it is possible that RBI starts to get more relaxed on the quantum of excess liquidity in the system over the next few months.
Investor Takeaways
We had recently analysed our structural view on Indian bonds and concluded that it remains very much intact post-election, with further evidence likely to be provided by the July Union Budget (https://bandhanmutual.com/article/16931). We think this is the big narrative for bonds that investors should continue to focus on with the obvious conclusion that the biggest risk is that of reinvestment risk. This is what investors should continue to plug, in our view, through appropriate duration selection on incremental fixed income investments. For the more near term, headline liquidity is poised to improve substantially over July and August as the high core liquidity level starts to get reflected more fully in headline liquidity with government spending picking up and bond maturities ahead. Hopefully, if the recent signs of some slowdown in credit growth persist, then RBI may be more relaxed in managing this system liquidity. Should food inflation dynamics start to stabilize, we wouldn’t rule out stance change in August with the prospects of modest rate cuts probably in play starting the October policy onwards. At any rate, and as noted before, there is precedence for stance not getting in the way of the first rate cut.
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