As widely expected, RBI’s Monetary Policy Committee (or MPC) maintained a status quo on policy rates. Consequently, the repo rate stands at 6%, the reverse repo rate at 5.75% and the Marginal Standing Facility (MSF) rate and Bank rate at 6.25%. Five members voted in favour of the monetary policy decision and one member voted for an increase in policy rates by 25bps. The MPC reiterated its commitment to keep headline inflation close to 4 per cent on a durable basis. Contrary to market expectations of a change in stance / tone to hawkish, it retained a neutral monetary policy stance.
For 2018-19, RBI estimates CPI inflation to be in the range of 5.1% to 5.6% in H1, including diminishing statistical HRA impact of central government employees and around 4.5% to 4.6% in H2, with risks tilted to the upside. RBI believes that the inflation outlook for next fiscal would be driven by various factors including international crude oil prices which have firmed up since August 2017 accompanied by an uptick in non-industrial raw material prices and monsoon, which has been assumed to be normal. The projected moderation in inflation in the second half is on account of strong favourable base effects (inflation rose quite sharply in Q3 2017), including unwinding of the 7th CPC’s HRA impact, a softer food inflation forecast, given the assumption of normal monsoon and effective supply management by the Government.
The MPC also outlined several factors that make the inflation outlook quite uncertain on the upside. These include the staggered impact of HRA increases by various state governments pushing up headline inflation and potentially inducing second-round effects (i.e. inflation in other items due to HRA increases). A pick-up in global growth exerting further pressure on crude oil and commodity prices and the proposal in the Union Budget to revise guidelines for arriving at minimum support prices for kharif crops, although impact would be assessed once further details are available. Further, the increase in customs duty on a number of items and the fiscal slippage as indicated in the Union Budget could impact the inflation outlook. Besides, the normalization of monetary policy by major advanced economies could further adversely impact financing conditions (borrowing costs) and undermine the confidence of external investors (probably impacting the currency and thereby inflation).
They have also pointed out a few mitigating factors or factors that could have a downward impact on inflation. These include subdued capacity utilization (currently at around 71% to 72%), potential softening in crude oil prices based on production response and moderate rural real wage growth. Clearly the upside risks outweigh factors that could contribute to a downside in inflation.
In terms of its growth outlook, GVA growth for 2018-19 is projected at 7.2% overall – in the range of 7.3%-7.4% in H1 and 7.1%-7.2% in H2 with risks evenly balanced. The outlook would be influenced by several factors including stabilization of GST implementation which augurs well for growth, signs of revival in investment activity as reflected in improving credit offtake, large resource mobilization from the primary capital market, and improving capital goods production and imports. The process of recapitalization of public sector banks, which is underway and large distressed borrowers being referenced for resolution under the Insolvency and Bankruptcy Code (IBC) should help improve credit flows further and create demand for fresh investment. Export growth is expected to improve further on account of improving global demand, although elevated commodity prices may act as a drag.
Impact on the economy
RBI has been concerned about the inadequate transmission by banks of lower policy rates to borrowers, particularly existing ones. This has been due to the different methods used for calculation of lending rates by banks – namely the Marginal Cost of funds based lending rates (MCLR) and Base Rate (typically used for existing loans). Since MCLR is more sensitive to policy rate signals, the RBI has decided to harmonize the methodology of linking benchmark rates by linking the Base Rate to the MCLR with effect from April 1, 2018. This should help in better transmission of interest rates thereby benefitting the economy particularly when policy rates are being reduced.
Impact on Morningstar Model Portfolios
10-year benchmark G-sec was trading at around 7.59% before the policy announcement, post which it fell by 7 bps closing at 7.53% as the tone of the RBI was not as hawkish as expected by a segment of market. Yields on the longer dated securities have moved up by around 45-55 bps with 10-year G-Sec yield moving up by 50 bps since the December policy meeting. This was mainly due to rise in US treasury bond yields, increase in inflation amid rising crude oil prices and concerns of fiscal slippage for the current year and next year.
RBI expects inflation to cool down in H2 2018-19 to levels of 4.5%-4.6% (which is close to their target of 4%) from 5.1% to 5.6% estimated in H1 2018-19. In our view, this indicates a prolonged pause in policy rates atleast upto August-September 2018. At that point, if RBI’s estimates for H2 inflation remain unchanged, the pause may extend further till upside risks to inflation materalise. Yields on medium and long-term debt would also take cues from the impact of rise in MSPs and crude oil prices on inflation; and policy action by global central banks to gauge RBI’s stance. Actual (vs budgeted) growth in tax and non-tax revenues, particularly GST collection and disinvestments would be closely watched.
Given this backdrop coupled with negligible expectations of further reduction in policy rates by RBI, makes shorter end of the yield curve relatively more attractive vis-à-vis longer end. We had shifted allocation (partially) from long term gilt & income funds to short and medium-term funds in the portfolios during our annual review (August 2017). Given that the debate has now shifted to the timing of start of the rate hike cycle, we would be reviewing our positions in long-term gilt and dynamic bond funds.
