Transcript of the Podcast :
RBI in its policy review yesterday on the 8th of February, changed its policy stance from accommodative to neutral citing expected higher economic growth and upside risks to its inflation forecast. Given the change in policy stance, repo rate at 6.25%, last cut by 25bps in October 2016, is likely to be held for some time to come unless data and events change RBI’s stance, positively or negatively.
Expectations were building on a rate cut after the Economic Survey 2016-17 released before the Union Budget 2017-18 suggested lower interest rates in the economy and the government stuck to a lower deficit target of 3.2% of GDP in its budget from 3.5% of GDP in the last budget. RBI, which has a specific CPI inflation target of 4% +/- 2%, sensed that risks were more on the upside than on the downside and held rates. The MPC (Monetary Policy Committee) that has 6 members, three RBI members and three government nominated members, voted unanimously to hold rates.
The fallout of the policy was a sharp rise in 10 year government bond yields that rose from 6.45% to 6.75% and is currently trading at levels of 6.82%. However, despite rise in government bond yields its not going to be a case of interest rates rising overall in the economy as repo rates will be kept at 6.25%, at seven year lows, and easy liquidity in the system will keep deposit rates and lending rates down.
Demonetization has led to a surge in deposits in the banking system and banks are faced with excess liquidity that will last for a while. RBI by turning policy neutral has pre-empted a liquidity driven asset price bubble that can lead to rising inflation expectations. Banks are still reeling under a deluge of bad loans and are reluctant lenders.
RBI has also taken note of the improving conditions in the global economy and the fact that Fed is likely to hike rates multiple times this year and ECB could stop its ultra accommodative policy stance towards the end of this year. A sharp reversal in global bond yields could lead to currency volatility, affecting the INR.
RBI policy while sounding hawkish to many is actually a growth policy with rates being kept low and liquidity being kept high in the system. A rate cut at this juncture would have actually served no purpose as bond markets anyway would have been sceptical on the long term sustainability of low bond yields in the face of Fed rate hikes, global economic growth and higher prospects of domestic economic growth.
RBI has come under a lot of criticism recently on the handling of the demonetization currency crisis and on its new way of functioning, which is similar to the Fed, ECB and other global central banks. Dr. Urjit Patel, the RBI governor is not as flamboyant as Dr. Raghuram Rajan who did not extend his term last year. However, the MPC has till now stuck to its mandate and has resisted any undue influences from the government or markets to push for growth, which by itself is a clear sustainable growth policy.
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