The RBI raised policy rates by 25 bps to 6.5%, with the MPC members voting 5-1 in favor of the hike. Importantly, the MPC retained its ‘neutral’ stance; which came as a big relief to the market.
Some key points were as follows:
1. The MPC now forecasts CPI ex-HRA at 4.4% in Q2, 4.7-4.8% (from 4.7%) in H2 and 5% in Q1 FY2020. It noted that the recent MSP hikes will have first and second round impact on CPI but that there is considerable uncertainty currently on its nature and scale. It also flagged other risks such as spatial distribution of monsoon rainfall (particularly its impact on paddy prices), crude oil prices, recent strengthening in core inflation (reflecting higher input costs and demand), rise in household inflation expectations, fiscal slippage, state government HRA revisions and volatile financial markets, which could be partially offset by GST rate cuts if passed through.
2. On GDP growth, the MPC retained its earlier forecasts of 7.4% for FY2019 (7.5-7.6% in H1 & 7.3-7.4% in H2) and projects Q1 FY2020 GDP growth at 7.5%. It noted that domestic activity continues to stay strong and that the output gap has closed. It also highlighted that the recent MSP hikes could boost rural demand (already buoyant as evident from earnings of FMCG companies) and investment activity has stayed strong despite tight financial conditions owing to increased FDI flows. However, it flagged the possible adverse impact on exports from rising global trade tensions.
Assessment
There had been some reassessment of views in some quarters post the recent fall in oil prices. However, by and large, market was comfortable with a 25 bps hike in the policy. the larger issue was the outlier risk of a stance change which may have then possibly signaled a series of rate hikes ahead. Equally, market may have then started speculating about some shift in liquidity stance as well. This would have caused further pressure on term premia in so far as the second half OMO bond purchase expectations may have had to be somewhat changed. However, as it turned out, the stance has been kept neutral. This is because risks are clearly considered to be 2 ways for both growth and inflation. Thus there is a recognition of the recent divergence in growth trends across major markets globally, and the risks that trade wars and financial market volatility poses. On CPI, offsets to the upside risks can potentially arise if the recent GST tax cuts are passed on and possibly also if the recent softness in commodity prices persists. The other point about liquidity has also been addressed with Deputy Governor Acharya largely indicating continuity in liquidity policy. This keeps market’s expectation of quantum second half OMOs intact.
The other noteworthy point here is that, after a long time, the RBI’s own CPI assessment seem to be lower than general market assessment. Thus for the second half of the financial year, the RBI assesses CPI to average 4.8% with risks evenly balanced (versus 4.7% assessed in last policy but with risks tilted to the upside). Not only has the risk assessment been downgraded (in exchange for a 10 bps hike in assessment), but the average is sub – 5% for the second half against most (including ours) assessment of a number comfortably in excess of 5%. However, there are still some qualifications to RBI’s projections including a fuller assessment of the first and second round effects of MSP hikes.
Takeaways
Our view has been of an up-fronted but shallow rate hike cycle. This has been basis an expectation that the moving up of average CPI in a context of higher global financial volatility merits a proactive response for a CPI targeting central bank. However, we also expect sequential growth momentum to start slowing over second half of the year. This is largely the reason for expecting a shallower rate cycle. The policy today is largely in line with this expectation. Barring a fresh escalation in commodity prices, there is nothing here that suggests a successive rate hike in October (Deputy Governor Acharya explicitly referred to the lags in monetary policy transmission). Also, most of the CPI divergence between market and RBI forecasts pertain to Q4 of the financial year. Should RBI’s estimates prove correct and the underlying context is a slowing growth momentum, then the last rate hike we are currently looking for may not be needed at all. However, if the truth is closer to what many in the market think today, then we would expect it to be delivered in Q4.
Irrespective, the portfolio strategy is largely the same for now. We remain overweight bonds upto 5 year for the most part with clear preference for quality (sovereign / AAA). There may be a case for further elongating duration over the latter part of the financial year once the view on both OMOs and CPI trajectory is somewhat clearer. Lower rated assets will suffer spread widening as refinancing pressures rise in an uncertain financing environment.
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