Expect policy rates to remain low : 06-12-2019

The hallmark of the last five policies under this governor has been that the market has been getting the rate action mostly right in every policy while missing the mark on the tone and dovishness of the MPC’s language. This policy was exactly the opposite. While the language was accommodative and as per expectations, most of the market got it wrong on the rate action.

Our rate cut expectations were premised on either of two factors. Either the MPC looks through the near-term inflationary pressures as transitory, caused by food spikes, and acknowledges the importance of low core inflation or the MPC places the objective of supporting growth as supreme and over-arching even as it chooses to tolerate a slightly higher than 4 per cent inflation outcome. The unanimous decision to keep rates unchanged indicates that the MPC is uncomfortable with CPI moving significantly away from the 4 per cent mark. This belief would have been reinforced by RBI studies which show that spillovers of food inflation into core inflation is high when food prices are high. Moreover, one-year-ahead household inflationary expectations have also risen by 180 bps in response to food price spikes and may have influenced the MPC’s decision.

The fact that the accommodative stance has been maintained and the assurance that they remain “ready to act” triggers the debate about the next policy. First, the published CPI prints into the next policy are likely to be higher than the current levels. Second, the uncertainty of the one-year-ahead inflation estimate is likely to continue with food inflation unlikely to have reversed in time for any more clarity.

The fact that the accommodative stance has been maintained and the assurance that they remain “ready to act” triggers the debate about the next policy. First, the published CPI prints into the next policy are likely to be higher than the current levels. Second, the uncertainty of the one-year-ahead inflation estimate is likely to continue with food inflation unlikely to have reversed in time for any more clarity.

Third, there are indications that the FY21 budget is also likely to be pro-growth and counter-cyclical leading to inflationary fears. This leads us to conclude that the next policy is also likely to be a pause. However, if sequential momentum in core CPI (from telecom tariffs, health, education etc.) does not rise as sharply as feared or if prices of food items start to taper off due to government actions, then a rate action for the April policy comes in to play.

This policy was also about the big debate on the steepness of the sovereign yield curve and the “lack of transmission” of the rate cuts on to the bond markets. More than the rate cut, there was a crying need for the RBI to flatten the multi-year high yield curve spreads. The RBI could have achieved this either by open market purchases of bonds (which however could not be justified from the liquidity angle) or by undertaking other unconventional policies.

Both expectations of these unconventional policy tools have been belied. Ironically, the ‘no action’ policy has actually triggered a bearish flattening of the curve rather than the bullish steepening that most of the markets were positioned for. It was, however, encouraging to note that the governor acknowledged the need for more flexible small savings rates in order to help the transmission process in deposit and loan rates.

Where does all this leave the markets? The bar for further easing is high given that our average CPI forecast for H12019 is close to 5 per cent. However, since we expect a Ushaped recovery, we are still not calling for the end of the rate cut cycle and expect policy rates to remain low for a long period of time. Worries on both the current year’s and FY21 borrowing program would come back into focus leading to a gradual uptick in long bond yields as we approach the next Budget.

Source : Times Of India