RBI Hikes Rates: Monetary Reasoning

RBI monetary policy committee (MPC) unanimously decided to increase the benchmark repo rate for the first time in more than four years, in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4 % within a band of +/- 2 %.

The rate changes after the MPC meet will be:

1.      Under Liquidity adjustment Facility(LAF) decided to raise Repo rate by 25 bps to 6.25%,
2.      The reverse repo rate under the LAF stands adjusted to 6.0 %, and
3.      The marginal standing facility (MSF) rate and the Bank Rate to 6.50 %.

Stance: Neutral

A neutral stance provides the Reserve Bank of India enough leeway to change rates in either direction in the next MPC. RBI Governor Urjit Patel said, “The MPC felt there was enough uncertainty to stick to neutral stance and yet respond to the risks to inflation target that have emerged in the recent months.”

A Rate hike was expected, but many experts felt that RBI might wait till the next MPC meet to hike Rates. This rate hike is being treated by some as a pre-emptive strike to insulate from the event risk on inflation in the future.

The major factors taken into account by the committee on deciding for a Rate hike were:

1.      Rising inflation concerns: The committee expects retail inflation at 4.8-4.9% in the first half of the year and at 4.7% in the second half of the year. Retail inflation, which is targeted was 4.58 % in the month of April, driven by a significant increase in inflation excluding food and fuel.                                                                                                                                (source: RBI)

2.      Global Factors: Global trade growth has continued to strengthen, though geo-political tensions contributed recently to declining export orders.  In Advanced Economies the Global economic activity has expanded albeit some momentum has been lost; Emerging Market Economies have generally been resilient. Oil prices increased for some period and the due to supply glut more or less stabilized.

3.      US Rate Cuts: This has increased the pressure on the Indian Rupee. Also, bond yields have risen on reduced foreign appetite for Emerging Markets debt due to growing dollar shortage in the global market and on prospects of higher interest rates in Advanced Economies. Stocks in major EMEs have faced sell offs on a rising dollar.

4.      Liquidity Surplus: During April, the Reserve Bank absorbed surplus liquidity of ₹496 billion on a daily net average basis due to increased government spending, especially in the second half of the month.

5.      Rural Demand: Improved rural demand on the back of a bumper harvest and the government’s thrust on rural housing and infrastructure. The monsoon forecast augurs well for the agricultural sector. According to RBI, October seems more likely by which better information about the impact of the MSPs on food prices can be gauged. As forecast by the IMD, if the monsoon is normal and well-distributed temporally and spatially, it may help keep food inflation in check.

Major Takeaways from RBI:Third Bi-monthly Monetary Policy, 2017-18

In the third Bi-monthly Monetary Policy review by the RBI, the Repo rates under the Liquidity Adjustment facility has been cut by 25 bps.

The rates as of now are:
Repo Rate: 6.0%
Reverse Repo Rate: 5.75%
Marginal Standing Facility Rate: 6.25%
Bank Rate: 6.25%

Inflation targeting, as always, played a major role in this decision as the policy decision seemed to be in line with the objective of achieving inflation target of 4 per cent within a band of +/- 2 per cent, while supporting growth.
The inflation projections of RBI are given in the chart below:

 Inflation is set to be affected by the following factors and their interactions:
(a) The impact on the CPI of the implementation of house rent allowances (HRA) under the 7th central pay commission (CPC);
(b) The impact of the price revisions withheld ahead of the GST ;
(c)  Implementation of farm loan waivers by States may result in possible fiscal slippages and undermine the quality of public spending and affect inflation;
(d) If States implement the allowances and salaries similar to Central, then RBI projects inflation to increase by 100bps over 18-24 months;
(e) A normal monsoon may keep food inflation under check;
(f) Farm loan waivers are likely to compel a cutback on capital expenditure;
(g) High levels of stress in twin balance sheets – banks and corporations – are likely to deter new investment; and
(h) The international commodity price outlook is fairly stable.

FOREX Reserves: US$ 392.9 Billion
Foreign Portfolio Investment: US$ 15.2 Billion ( Debt+Equity )
FPI remain bullish on the outlook for the Indian Economy.
Surplus Liquidity: There is surplus liquidity in the system which is exacerbated by the budgetary spending of Government.RBI seems to be actively monitoring the situation and actively managing the excess liquidity as is stated in the policy statement:"Surplus Liquidity of Rs. 1 trillion was absorbed through issuance of treasury bills (TBs) under the Market Stabilisation Scheme( MSS), and Rs. 1.3 trillion through Cash Management Bills (CMBs) so far this fiscal year".
Export-Import:
The export growth subdued as the value of commodities exported either slowed or declined.
Import growth on the other hand remained high due to two main reasons: Surge in Oil Imports, and stockpiling of Gold imports ahead of GST implementation.