A rate hike was
widely expected from the Reserve Bank today. The RBI was not expected to change its policy stance from the neutral to “tight” or to “withdrawal of accommodation”. The policy statement lived up to these expectations as well.
Post policy, bond prices rose and yields fell. That’s a rather peculiar reaction to a rate hike. Bond prices normally fall and yields rise post a rate hike. Possibly today the market reacted the other way precisely because it has been pricing in 2-3 rate hikes all the way from February or March.
Market positioning was light ahead of policy and the buying today was probably because traders don’t expect three rate hikes in a row. So if the October policy is a hike-holiday, then some long play is possible.But what other takeaways from the policy. Here are some thoughts :
Beyond the rate hike, the MPC has raised its inflation forecast for the second half of this year to 4.8 percent from 4.7 percent earlier.
Also it has given a forecast of 5 percent for April-June 2019. Further it has reiterated that its goal is to get inflation to 4 percent. So that’s the clue. Clearly if the RBI is interpreting its mandate as 4 percent and not 4 percent (+/-2 percent) then it will have to press with rate hikes - may be one or two more by mid 2019.
Secondly, most bankers said that they won’t be raising their lending or deposit rates just yet post the repo rate hike, because liquidity is comfortable. Clearly if the RBI means business, if it wants its rate hikes to be transmitted it will have to suck out liquidity. This may be easy. As deputy governor Viral Acharya said going into festival season, more cash will be withdrawn from banks and liquidity will tighten naturally.
RBI may replace some of this cash by buying bonds, but it is unlikely to go the whole hog. It may keep the system tight especially if inflation pans out as per its forecast or even overshoots its forecast because of the high Minimum Support Prices for crops and/or higher crude oil prices.
Third, in all this, what sticks out like a sore thumb is the RBI’s “neutral” policy stance. The RBI moved to neutral stance in Febraury 2017. CPI has fallen from 5 percent in that month to a low of 1.5 percent in July 2017 and back to 5 percent by the end of the year.
Yet the policy remained ”neutral” In the past 3 months it has hiked rates twice and is forecasting an inflation level one percentage point higher than its mandated target. And still the stance is “neutral”. It is either time for the RBI to stop giving a stance or it is time for the market to ignore it.
Fourth, there is a growing confusion over how the RBI is reading its mandate. If it serious about 4 percent ( as it often reiterates) then today its language didn’t sound as hawkish as it ought to. Keeping the liquidity accommodative to neutral also shows that it is not going full throttle at reaching 4 percent. Looks like the RBI has chosen to hasten slowly. Fifth the RBI’s attitude to the currency is raising worries in some quarters. The two rate hikes have strengthened the rupee. The central bank has also spent close to 25 billion dollars in this financial year from its reserves to slow down the rupee depreciation.
Yes the rupee has depreciated about 5 percent this financial year, but it is still more than 15 percent over valued in REER terms (real effective exchange rate terms). At a time when the yuan is depreciating, and India’s exports are stagnating and the trade deficit is rising every month, the currency strengthened by interventions and rate hikes may exacerbate the current account deficit.
Some believe the RBI is probably being nudged by the polity to keep the rupee strong in an election year on the (mistaken) belief that a strong currency means a strong country. But exchange rate is a catch-22 dilemma for the RBI. If it has to target inflation it can’t allow the rupee to weaken. If it keeps the rupee strong it runs the risk of higher current account deficit which can endanger financial stability.
Inflation weighs on the MPC
The RBI is probably calculating that it is ensuring financial stability more by keeping inflation in check. Its calculation may well be right. India went into the fragile five basket in 2013 not merely because of a high current account deficit but also because it was accompanied by high inflation. This time around RBI is ensuring that the variables within its control are kept in check, as the governor argued. That said, the stable rupee in the face of a widening trade deficit is still worrisome.
Finally a word of praise for the non-monetary announcement in this policy. The RBI is looking as goading banks to liaise with NBFCs(non bank finance companies ) to ensure better financial inclusion. It has announced that it would like to see co-origination of loans.
Banks have cheaper cash thanks to deposits, NBFCs have better last-mile reach and a combined approach to financial inclusion should work. Ideally these partnerships between banks and NBFCs should have been forged without the regulator’s intervention. But given different regulatory frameworks for the two, may be the RBI’s intervention is necessary to frame rule for loans originated together. One hopes this is the start of an interesting and successful experiment.
Read our coverage of the RBI's rate decision