Monetary Policy: Policy Rates now at 9 year low

RBI CUTS POLICY RATE BY 35BPS. THE GDP PROJECTION HAS BEEN REVISED DOWNWARDS TO 6.9% OWING TO DEMAND AND INVESMENT SLOWDOWN

In the 3rd bi-monthly monetary policy, the RBI reduced the repo rate by 35bps bringing it down to 5.4%. Consequently, the reverse repo rate stands reduced to 5.15%. The MSF rate stands at 5.65%. The MPC has maintained “accommodative” stance. The decision to reduce the repo rate was unanimous however a 35bps cut was favored by 4 out of 6 members of the monetary policy committee while 2 members favored a 25bps cut. With this reduction the policy rate is at near 9 year lows. The last time the rate was seen at these levels was during 2010, which was the year of extreme slowdown post the financial crises and the policy rates were reduced significantly. Rates were reduced to 4.75% in 2009 to boost economic growth and investment demand.

The key takeaways are as below:

INFLATION OUTLOOK

Consumer Price Inflation has been quite muted despite the recent marginal upward movement, mostly on account of deflation in food prices. Food inflation remains low at
2.4% causing retail inflation print to be in comfortable zone of 3.18%. Inflation in the fuel and light group moderated in June, with electricity moving into deflation. Fuels such as firewood and chips, and dung cake have been in deflation from April. Core inflation remains in comfortable zone at 4%. Growth in wage cost is muted both in rural and manufacturing sector.

Monsoon so far has been lower with uneven spatial distribution which might put pressure on food prices, but the recent pick up in rainfall may offset the price impact.
Crude oil price has fallen significantly over the past one year and has provided a good cushion to the domestic inflation. The crude oil prices though may remain volatile, but the global slowdown narative remain overpowering on the current price movement. CPI inflation is projected at 3.1 per cent for Q2FY20 and 3.5-3.7 per cent for H2FY20, with risks evenly balanced. CPI inflation for Q1FY21 is projected at 3.6 per cent.

LIQUIDITY POSITION

Average liquidity in the system has risen significantly in the past 3 months. The system which was running in deficit turned positive by end of May and hover at near 2 lakh cores. Some of the reasons pointed out for large surplus are:
a) Return of currency to the banking system;
b) Drawdown of excess cash reserve ratio (CRR) balances by banks;
c) OMO purchase auctions done worth ₹52,500cr since Apr’19
d) The Reserve Bank’s foreign exchange market operations.
A high liquidity surplus helps in easy transmission of policy rates and hence further aids the cause of the RBI rate dissemination. However, despite the large surplus the transmission is quite low. The capital markets have been more efficient in aligning to the policy rate while the bank have reduced the rates by meagre 29bps as compared to rate cut of 75bps by the RBI since Feb 2019. Moreover, with lack of investment opportunities, banks are benefited by the increase in deposit growth.

ECONOMIC GROWTH

Index of industrial production (IIP), moderated in May 2019, pulled down by manufacturing and mining. The production of capital goods and consumer durables decelerated. The monsoon rainfall so far has been 6% lower than the long period average leading to a 6.6% reduction in kharif crop sowing. Rainfall for the second half is expected to be normal by IMD. High frequency indicators of services sector activity for May-June present a mixed picture. Tractor and motorcycle sales – indicators of rural demand – continued to contract. Amongst 3 indicators of urban demand, passenger vehicle sales contracted for the eighth consecutive month in June; however, domestic air passenger traffic growth turned positive in June. Commercial vehicle sales slowed down even after adjusting for base effects. Various high frequency indicators suggest weakening of both domestic and external demand conditions. With above factors in play the RBI has revised downward its forecast for GDP to 6.9% from 7%. The RBI has taken in to consideration the expected positive impact of reduced interest rates and lower base in arriving at the GDP projection.

VIEW

Bond markets had already factored in a rate cut before the policy announcement and hence the movement of the yield curve remained restricted. The short end of the sovereign curve saw yields coming down by 6-10bps, however the 10 year yield which has already demonstrated a strong rally saw some profit booking. The forward glide path for the interest rates remains downward sloping and hence investment in short to medium duration instrument is advisable. As the per the policy statement

“Even as past rate cuts are being gradually transmitted to the real economy, the benign inflation outlook provides headroom for policy action to close the negative output gap. Addressing growth concerns by boosting aggregate demand, especially private investment, assumes the highest priority at this juncture while remaining consistent with the inflation mandate.”

Although with the current rate reduction, the policy rates have dropped to nearly a decade low, the current growth situation and the enhanced focus of the central bank towards boosting private investment and aggregate demand, presents a glimmer of hope for further mild rate reduction.

Investor in long and medium duration bonds and funds may continue to hold till the complete cycle of rate reduction is complete. Fresh investment in short to medium term is recommended with a 1 year above investment horizon. We recommend investment in good quality short term Funds and Banking & PSU Debt Funds. Investors are advised to take a cautious stance toward credit risk funds and avoid fresh investment at this juncture. A mix of good quality debt funds, tax free bonds, FMPs, NCDs, etc., would be ideal for a moderate risk investor.

Please see below the recommended schemes:

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