Inflation, Dollar, notes: Takeaways from the RBI's Monetary Policy review

Contrary to expectations, RBI has kept the repo rate unchanged at 6.25%

Contrary to expectations, the Reserve Bank of India (RBI) has kept the repo rate – the rate at which the banks borrow from the central bank – unchanged at 6.25% while reviewing the Monetary Policy on Wednesday, the first policy since the government’s demonetisation drive in November. The reverse repo rate under the LAF remains unchanged at 5.75%, and the marginal standing facility (MSF) rate and the Bank Rate at 6.75%.

"Despite the surprise today, we believe the RBI’s decision to stand pat is a prudent one. We also expect demonetisation to hurt short-term activity, but we do not see any medium-term damage as it will only result in wealth redistribution, and not much wealth destruction. Moreover, while headline inflation is low, underlying inflation has stabilised around 5%," said Sonal Varma, Nomura's Chief India Economist.

"As such, in the light of improved banking system liquidity, the focus needs to be more on the transmission of the rate cuts already delivered, rather than lowering the signalling rates much further," she adds.
 

"This is a good tactical call as this will still leave a chance with RBI Governor to see how the global economy reacts to tnhe US FED move and then take a call on domestic interest rates. If the rate hike in US happens then that will increase the probability of flows moving away from EM and into US treasury. With the reduction of domestic interest rates there would be additional outflow from Domestic debt as the gap between risk adjusted return in domestic debt vs US treasury reduces substantially," said Motilal Oswal, chairman & managing director, Motilal Oswal Financial Services.

Here are five key takeaways from the RBI’s Monetary Policy review:

Demonetisation impact: The RBI, while reviwing the policy, acknowledged that the demonetisation move has impacted economic momentum. As a result, incorporating the expected loss of growth momentum in Q3 and waning effects in Q4 alongside the boost to consumption demand from higher agricultural output and the implementation of the 7th Central Pay Commission (CPC) award, the RBI has revised down the gross value added (GVA) growth for 2016-17 from 7.6% to 7.1%.

Also Read: Issued 19 billion notes since demonetisation:RBI

“The outlook for GVA growth for 2016-17 has turned uncertain after the unexpected loss of momentum by 50 basis points (bps) in Q2 and the effects of the withdrawal of specified bank noted (SBNs) which are still playing out,” the RBI said.

Incremental CRR withdrawn: The RBI has decided to withdraw the incremental CRR effective the fortnight beginning December 10, 2016. It had announced an incremental CRR of 100% of the increase in net demand and time liabilities (NDTL) of scheduled banks between September 16, 2016 and November 11, 2016 effective the fortnight beginning November 26, 2016. The move was aimed at absorbing a part of the large increase in liquidity in the system following the demonetisation of Rs 500 and Rs 1000 notes in November.

Food inflation: While reviewing the policy, the RBI also took note of the upturn in the prices of several items that is masked by the easing of inflation on base effects during October. Given the demonetisation, the RBI feels that the prices of perishable items could soften in November, though the final reading will be available only in December.

RBI feels the withdrawal of specified bank notes (SBNs), or demonetisation as it is popularly called, could result in a possible temporary reduction in inflation of the order of 10-15 basis points (bps) in Q3. Taking these factors into account, headline inflation is projected at 5% in Q4FY17, with risks tilted to the upside but lower than in the October policy review.

“Prices of housing, fuel and light, health, transport and communication, pan, tobacco and intoxicants, and education – together accounting for 38% of the CPI basket – may remain largely unaffected. Going forward, base effects are expected to reverse and turn unfavourable in December and February. If the usual winter moderation in food prices does not materialise due to the disruptions, food inflation pressures could re-emerge,” the RBI statement said.

Rate hike by the US Fed: Though the RBI believes the global financial markets are already factoring in the possibility of a rate hike by the US Federal Reserve (US Fed), it does not rule out the heightened volatility.

“Global developments, especially as financial markets factor in the future stance of US monetary and fiscal policy, could impart volatility to the exchange rate thereby feeding into inflation. On balance, therefore, it is prudent to wait and watch how these factors play out and impinge upon the outlook. Accordingly, the policy repo rate has been kept on hold in this review, while retaining an accommodative policy stance,” the RBI said.

Oil prices: The RBI also took note of the recent move by the OPEC to cut production, which could see crude prices firm up in the coming months. This in turn, the RBI feels, could fuel inflation.