The MPC delivered a surprise 50 bps cut against consensus market expectation of 25 bps. With average CPI projection cut to 3.7% for the year, and growth needing a leg-up especially with global uncertainties in play, the MPC found it judicious to upfront the rate cut and thus facilitate ongoing transmission of lower rates to the wider economy. As if this was not surprise enough, the Governor also announced a 100 bps CRR cut over 4 fortnights from September. This will add INR 2.5 lakh crores of additional liquidity by December. Again, this is to ensure no road-blocks to transmission since, presumably, lenders will already have future visibility on liquidity over the so-called ‘busy’ season on credit.
So far so good, but then here came the twist: the MPC chose to change stance to ‘neutral’, after having just shifted to ‘accommodative’ in the April policy. The Governor also spelled out more clearly what this means: that monetary policy is left with very limited space to support growth and things going ahead will be more incrementally data dependent. We delve into a more detailed analysis below:
Transmission Is The Key
It is somewhat stating the obvious, but the consistent theme for monetary policy over the past few months is creating conditions for a speedy transmission of rate cuts. Thus, the RBI has time and again surprised on the size of liquidity infusions over the past few months. Indeed, the core system liquidity as per our estimates post dividend is in excess of INR 6 lakh crores. As discussed above, the upfronted rate cut today and the pre-commitment to forward CRR cuts should be seen in the same light; that there should be no impediment whatsoever towards transmission. However, in our view, the unnecessary wrinkle is the change of stance back to neutral after just one policy and the explicit statement that “monetary policy is left with very limited space to support growth”.
Don’t Under-estimate The Expectation Channel
Transmission happens not only via the current level of funding cost, but to some extent also reflects the expectation with respect to this cost. By changing stance to neutral and declaring limits on monetary policy, the MPC has actively curbed the expectation channel when there was little point in doing so at this juncture, in our view. To be clear, almost no one in the market thinks there is very much more room on the repo rate. Thus, our view of terminal rate of 5.5% is met after today, and even the most aggressive forecast would not be seeing repo rate below 5%. However, the market’s mind works on ‘what-ifs’. Thus, we ourselves have left open the idea that the terminal repo rate can still be lower, should global growth come under further pressure. Indeed, this is looking more likely to us now than even a few months back. The same may very well be running in the MPC’s minds as well. However, the proactive shift to neutral stance forces the bar higher in market’s mind and works to some extent counter to the over-arching objective of transmission. The clearest manifestation of this can be seen in the post policy action in the market, where aggressive curve steepening is underway as most participants move to price out any further rate cuts.
Relatedly, and while it is well understood that the stance only indicates probability of directional change in policy rate, it is curious that the stance of policy had such a limited shelf-life. This is when the global economic format is yet only of heightened uncertainty with the actual impact of this on hard economic data is still pending. Also, in strict theory, an accommodative stance denotes propensity to stay on hold or cut and thus is much better suited for the current period from that sense as well.
That Said, Market Transmission Will Progress
The first reaction of the market, in the form of aggressive curve steepening, largely reflects two things: One, in most of the market’s mind the rate cycle is over. Two, any expectation of OMO purchases later in the year have been now effectively shelved with the CRR cut from September. Thus, the immediate response is to shun duration and buy ‘front end’ (up to 5 years largely). That despite an enviable set of macros and a painfully established fiscal credibility, this is the market’s reaction should be of some concern to the RBI insofar that it reflects market’s doubts on durability of transmission.
Having said that, we would think that this initial reaction is a bit extreme and will give way to some amount of balance going forward. This is for the precise reasons mentioned above: India’s macros are solid and government’s fiscal stance is conservative and credible. Globally, the dollar is weakening and we expect this to be soon followed up with US yields breaking lower as well, as hard data starts to reflect ongoing economic uncertainties. This combination will also likely restart bond flows to well run and sizeable emerging markets like India.
Also, while the RBI’s current policy action has generated shock and awe, this is more an upfronting rather than going overboard and is unlikely to generate concerns on incremental inflation. Even from a liquidity standpoint, while prima-facie the action seems excessive, the RBI has also been consistently bringing down its forward dollar short book (USD 52.5 billion short position up to 1 year as at end of April versus USD 78.7 billion at end of February) which also impacts rupee liquidity. Also liquidity, as with everything else, has diminishing marginal utility and by itself may not be sufficient to generate a renewed large uptake in credit growth. This is especially so because of the exceptionally large global uncertainty coming in the way of a meaningful local private sector capex cycle for the time being even as segments of retail credit are decidedly getting saturated.
Thus, and as discussed in a recent market note, the market may soon be comfortable with a view that the new levels of looser financial conditions are more sustainable. With a conducive global set-up as a backdrop, this may generate incremental duration demand as well especially as the levels on front end bonds soon approach levels that leave little on the table for gains incrementally.
Source: RBI and Bandhan Internal Research
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