As widely expected, RBI’s Monetary Policy Committee, or MPC, maintained a status quo on policy rates and retained a neutral monetary policy stance. Consequently, the repo rate stands at 6%, the reverse repo rate at 5.75% and the Marginal Standing Facility, or 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% on a durable basis.
The RBI revised its projection for Consumer Price Index, or CPI, inflation to a range of 4.7% - 5.1% in H1 (previous projection range of 5.1% to 5.6%) and 4.4% in H2 (previous projection range of 4.5% to 4.6%), including the HRA impact for central government employees, with risks tilted to the upside. The statistical impact of the HRA revisions will be looked through, accordingly after excluding the statistical impact, CPI inflation is projected in a range of 4.4% - 4.7% in H1:2018-19 and 4.4% in H2. This revision reflects recent softening in food prices, signals from the RBI’s forward-looking surveys, and estimates from structural and other models.
The MPC also outlined several factors that make the inflation outlook uncertain on the upside. These include international crude oil prices which has been volatile in the recent period. Revised guidelines for arriving at minimum support prices, or MSP, for kharif crops announced in the Union Budget. 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). Besides, any further fiscal slippage (both at central and state levels) from the budgeted estimates for 2018-19 and non-normal monsoon may have a significant bearing on inflation outlook.
The central bank also revised its growth outlook and switched to GDP as a headline measure of economic activity. The GDP growth for 2018-19 is now projected at 7.4% overall – in the range of 7.3%-7.4% in H1 and 7.3%-7.6% 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 improvement in credit off-take which signifies revival in manufacturing sector and new investment activity, and large resource mobilization from the primary capital market which could strengthen investment activity. The process of recapitalization of public sector banks and resolution of distressed assets under the Insolvency and Bankruptcy Code may improve the business and investment environment. Focus on rural and infrastructure sectors in the Union Budget could revive rural demand and crowd in private investment. Export growth is expected to improve further on account of improving global demand, although elevated commodity prices may act as a drag. However, there are two major risks to the growth outlook. First, protectionist trade measures announced by US and threat of a trade war. Second, the uncertainty over the pace and timing of monetary policy normalisation by the central banks in advanced economies which may have an adverse impact on capital flows and overall investment sentiment.
Impact on Morningstar Model Portfolios
The 10-year benchmark G-sec was trading at around 7.23% before the policy announcement, post which it fell by 11 bps closing at 7.12%. Yields on the 10-year G-Sec yield have moved down around 60-65 bps in last one-month post touching a two-year peak of 7.81%. Yields fell post release of the Government’s borrowing calendar for H1 of FY2018-19. The Government plans to auction INR 2.88 trillion worth of bonds in H1, which is around 52% of the revised budgeted amount of Rs 5.55 trillion for the full fiscal year, against the practice of borrowing around 60% of the budgeted amount in previous years. Increased issuance of bonds on the shorter end of the curve i.e. 2 - 5 years and reducing the amount of issuance in the medium-term range (10-14 years) to 29%, as compared to more than 50% in the previous years, improved market sentiments. Also, measures taken by RBI to help banks in reducing the MTM impact of their holding in government securities further boosted sentiments.
The central bank expects inflation to cool down in H2 2018-19 to 4.4% (which is close to their target of 4%) from 4.7% to 5.1% estimated in H1 2018-19. In our view, we continue to expect a prolonged pause in policy rates at least up to 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. Given favorable revision of both inflation and growth outlook, yields on medium and long-term debt would take cues from the factors stated above. At this juncture, we believe that shorter end of the yield curve is relatively more attractive vis-a-vis longer end. Accordingly, we had shifted allocation from long term gilt funds to short term funds in the portfolios last month.
