RBI Monetary Policy Decision

RBI will announce the monetary policy decision today where the consensus is for a last 25 bps rate hike in the current cycle to a terminal rate of 6.50%. 

While there is a loss of growth momentum but the economic activity is in a position of strength. The major headwind is from a global slowdown as a result of sharp interest rate hikes. Headline inflation is to decelerate in the quarters ahead but the stickiness of core inflation is a concern and RBI rhetoric during the last policy focussed on putting the inflation beast down. 

I am leaning with the consensus expectations of a 25 bps rate hike. Regarding the monetary policy stance, I think it would continue with "withdrawal of accommodation"

Let's begin by reviewing some of the important data points:

1. Manufacturing PMI reading came in at 55.40 clearly showing a loss of growth momentum though still in expansion mode. A key area of weakness in the report was "Exports" which increased marginally at best and moderated to a 10 month low. There was robust increase in new work and mild resurgence in cost pressures on demand resilience. 

2. Services PMI  reading came in at 57.20 from prior 58.50 exhibiting a slight loss of momentum. While demand was resilient, input cost inflation moderated which saw only a moderate upturn in pass through of prices. 

3. Rabi sowing has been on a strong note. Refer to the chart by Business Standard below:

4.  The trade deficit numbers released last month shows deceleration in merchandise goods deficit and a strong services sector performance.

5. The CPI inflation fell to 5.72% in December driven by disinflation in food and beverages while WPI inflation fell to 4.95% after peaking at a whopping 15.88% in May 2022. The winter disinflation in vegetable prices is likely to see softening in the CPI print. The There has been disinflation in the price of pulses (except for Masoor Dal), edible oils and vegetables. However, prices of cereals have seen a mom rise of close to 2% and milk prices continue to be elevated and have seen a rise 4 days back. Inflation is estimated to fall down as the year progresses - first on seasonality and then as higher base effects kicks in, however, RBI in the last policy statement highlighted the concerns around stickiness in core inflation. My own estimates for January inflation are for a reading of 5.70% and for Q4 to average 5.32%. 

Revision in RBIs inflation projections will be keenly watched as oil prices have stabilised in the $ 78 - $ 88 price band whereas RBI assumptions are for a $ 100 crude oil price.

The forward real rates are positive and policy is in a restrictive pace. 

6. Liquidity continues to be in surplus but mismatches in tax collections on account of GST / Advance tax / Excise duties and Government spending has seen LAF going into deficit and overnight rates trading above the upper bound of the policy corridor at 6.50%. In my earlier note on liquidity, I had spoken about the coming maturity of outstanding operations of RBI. In the month of March, we have 13K crore of LTRO and TLTRO maturity. Likewise for April, maturity amount stands at 61K crore. 

As of Feb 7, 2022, the SDF amount is at 100K crore and the amount in variable rate reverse repo stands at 35K crore. The O/S Liquidity operations of the RBI are to the tune of 86K crore out of which 74K will be maturing in the next 2 months. As these operations mature, the amount in SDF will reduce to that extent. 

Let's add another dimension - the durable liquidity as on 13 Jan 23 is at 251K crore which will get reduced on account of increase in CIC (refer to my earlier article) and RBI intervention to manage the current USD outflow. 

So I estimate that liquidity will turn negative by second quarter of 2023.

The tightening in liquidity conditions is expected to push the overnight rate to upper bound of the corridor (MSF Rate).

Stance of monetary policy

Is it warranted at this juncture for RBI to change the monetary policy stance from "withdrawal of accommodation" to "neutral". My personal take is since there are still outstanding operations, there will be no change in stance until the next policy in April 2023. 

According to the Liquidity management framework, "Banking liquidity being kept in deficit or in surplus mode is a design feature of the liquidity management framework – whether it is the corridor system or the floor system, or, analogously, whether the policy rate is the repo rate or the reverse-repo rate. It does not reflect, or depend upon, the monetary policy stance (neutral, tightening or accommodative), because monetary policy stance, under an inflation targeting framework conducted through changes in interest rate, hinges on the direction of policy rate. The choice between the two systems, therefore, depends on the prevailing liquidity climate."

Under the corridor system, the system liquidity would generally be in a small deficit of 0.25% - 0.50%.

Let's say, they do rationalize a change in stance , what would it mean for the markets? 

So a change in stance to "Neutral" could signal a peak in interest rate cycle and see receiving in rates.