The MPC hiked repo rate by 25 bps to 6.50% as was widely expected. It did so with a 4 : 2 vote, also widely expected. The stance was retained at ‘withdrawal of accommodation’ which, though within the realm of expectations, was nevertheless a touch disappointing for the market given that on literal reading it keeps the rate hike cycle still in play. The fall in food prices was acknowledged but the stickiness in core inflation was flagged, again very consistent with recent RBI communication.
Understand where they are coming from…
We have been appreciative for some time, of the timely and firm ‘pivot’ that RBI has executed over the past year. The focus of core inflation over the last few policies, similarly, is natural to a credible CPI targeting central bank. This is especially needed given the highly uncertain global environment and corresponding volatility in global capital flows. Lately there has been somewhat of a turn in the wind, so to speak, with the Fed explicitly acknowledging that the disinflation process has begun in the US. While encouraging, there is nevertheless enough scope still for volatility in incoming data to keep shifting market’s interest rate expectations around. A case in point was the recent payroll data in the US which showed outlier strength in terms of jobs created even as the more critical hourly earnings growth continued to de-accelerate. Given this context it is prudent for emerging market central banks including India, to maintain guard on monetary policy.
…But differ on where we are going
A defining feature of the current global monetary tightening cycle has been the pace of such tightening which stands out in terms of the aggression shown over such a short period of time. As is well known and accepted, monetary policy changes impact economic activity with a few quarters’ lag. Thus concurrent data, while indicating robustness, doesn’t necessarily have very concrete information about the future. RBI notes the improvement in global growth lately as well as the strong concurrent local data. However, the picture may look somewhat different down the line when the cumulative impact of this tightening cycle begins to get felt into economic activity. This is especially true since India’s total fiscal and monetary stimulus over the pandemic wasn’t overboard at all and its removal has been fairly proactive (considering aggregate public sector deficit here and not just the centre’s). Thus the monetary tightening isn’t having to first neutralise the overhang of previous stimuli and then move to curtailing aggregate demand. This is unlike the setup in the west. Also, while there is some improvement in outlook for global growth recently this assessment itself is subject to change. This is especially true given the point above on cumulative tightening yet to fully be felt in economic data. Thus we retain our view that RBI growth forecast is somewhat optimistic and we currently lean towards expecting around 100 bps or thereabouts undershoot to the 6.4% growth forecasted by RBI for FY24. If we are right in this then core inflation pressures should also start to abate over the year ahead, assuming no further meaningful supply shocks / rigidities.
The matter of the stance
The fly in the ointment, so to speak, in the policy today is the retaining of ‘withdrawal of accommodation’ stance. The Governor continues to justify that on the current real positive rates basis immediate forward forecasted inflation as well as the level of system liquidity, when contrasted with a point in time prior to the pandemic. In the post policy press conference, however, Deputy Governor Patra clarified that the desired real positive policy rates will be adjusted basis evolving growth-inflation dynamics and not necessarily benchmarked to a point in time in the past.
Our view is that RBI will move to neutral stance in the April policy. The real rate will progressively increase without further change in nominal policy rates since projected inflation continues to fall. The more important point is around liquidity. While the Governor has referred to the drain from the upcoming scheduled redemption of LTRO and TLTRO funds, an even bigger drain will be on account of seasonal currency in circulation rise between now and early May. This could be of the order of INR 2 lakh crores. Even assuming some modest inflows on forex, this will still take core liquidity close to neutral by early May. This will likely meet the other condition on liquidity for turning stance to neutral. The modest but continuous OMO sales in secondary market are somewhat bewildering if one sees the future core liquidity forecast. If at all, the question will likely soon move to when to expect permanent liquidity infusion from RBI.
Takeaways
While initially disappointing for the bond market, the policy does nothing to change our view that policy rate has peaked in India. If anything some back up in yields may provide a welcome opportunity to continue allocating to quality fixed income. The broader narrative, in our view, is that worst of the pressures on our current account deficit and inflation that emanated from the commodity shock seem to be behind us. Global bond volatility has largely stabilised, or at least is now following tradeable ranges, reflecting terminal policy rate expectations stabilising in most major markets. India’s policy cycle has peaked but (as an example) 4 year government bond yield is still almost 75 bps over this peak, at the time of writing. Further real yields are now positive across all tenors assuming a reasonable expected inflation in the future. Finally, given the relative flatness of the yield curve and low credit spreads, investors don’t have to take either too much of duration or credit risk in building fixed income allocations.
We reiterate our overweight stance on 3 – 6 year government bonds for medium term investments. For shorter horizons of 6 – 9 months onwards, quality money market rates have also repriced significantly thereby making money market / ultra short / low duration funds investable for these time horizons.
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