Monetary Policy Review Premature end to the easing cycle?

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1 The monetary policy committee (MPC) maintained status quo for the second policy review running, keeping Repo rate at 6.25%, contrary to market expectations of 25bps cut. Consequently, the reverse repo/msf stays at 5.75%/ 6.75%, maintaining the policy rate corridor of +/-50bps. However, what has come as a surprise to market participants is the change in RBI stance from accommodative (running since Jan 15) to neutral, as RBI shifts its focus to achieving its medium term inflation target of 4% on a durable and calibrated basis. The RBI s focus has shifted towards core inflation (sticky at 5%) rather than headline inflation. RBI policy statement states The Committee remains committed to bringing headline inflation closer to 4.0 per cent on a durable basis and in a calibrated manner. This requires further significant decline in inflation expectations, especially since the services component of inflation that is sensitive to wage movements has been sticky. The committee decided to change the stance from accommodative to neutral while keeping the policy rate on hold to assess how the transitory effects of demonetisation on inflation and the output gap play out. RBI sees inflation ending FY18 at 4.8% with risks evenly balanced: The focal point of the policy seems to have moved to underlying inflationary pressures which are reflected in the stickiness of core inflation. The MPC views persistence of core inflation to have second-round effects, which could put a floor to headline inflation. The MPC mentions that the current fall in consumer prices is largely food led (Dec 16 CPI would have been up 140 bps higher without vegetable prices fall) which could potentially rebound as the demonetization impact wears off. The MPC sees inflation in the range of % in the 1HFY18, moving higher to 4.5-5% in 2HFY18 as base effect wanes and output gap closes as growth recovers. RBI sees upside risks to the trajectory arising from a) the hardening of international crude prices, b) volatility in the exchange rate on account of global financial market developments and c) effects of the house rent allowances under the 7 th pay commission. However, government s commitment to fiscal prudence should help limit upside risks to inflation. RBI reduced GVA growth for FY17 to 6.9% from 7.1% and FY18 GVA growth estimated at 7.4%: The MPC sees the impact of demonetization transitory with GDP growth expected to recover in FY18 as 1. Discretionary consumer demand held back by demonetization bounces back by the end of Q4FY Economic activity in cash-intensive and unorganized sector is expected to be restored rapidly. 3. Demonetization-induced easing in bank funding conditions has lead to a sharp improvement in transmission of past policy rate reductions to lending rates which should spur a pick-up in both consumption and investment demand. 4. Government s focus on increasing capital expenditure, boosting the rural economy and affordable housing while maintaining fiscal prudence should aid also growth recovery further. Rates Outlook: Prior to the current policy review, we were of the view that 50bps rate cuts was still on the cards in FY18 as, a) inflation would remain within RBI s comfort zone, b) government stayed committed to fiscal prudence, and c) surplus liquidity would help in better transmission of rates. Also, real rates an important 1 P a g e 1 0 F e b r u a r y

2 variable in RBI s monetary framework (discussed in pages 4-5) is above 250bps compared to RBI s target of bps, indicating room for some more easing. However, three decisive shifts in the current policy statement as discussed below, indicates that RBI is likely to keep rate easing on hold for the rest of FY18 which in our view is a premature end to the easing cycle. 1. Despite stability in macroeconomic conditions over the last few months in the face of demonetization, RBI has shifted its monetary stance from accommodative to neutral focusing on its medium-term target of 4%. This has set the bar extremely high for future rate cuts, given that structurally India s long term dynamics (consumption oriented, demographics, rising per capita) in the face of supply side issues would keep inflation higher than target in the long run. 2. The above dynamics is reflected in core inflation (44% weight in CPI Index) which has been sticky-torising (moved up to 5%) over the last year. The shift in focus to core from headline was surprising in our view and further raises the bar on future rate cuts. 3. RBI s own estimate of headline CPI inflation for FY18 sees upward bias especially through the feed through on account of HRA from the 7 th CPC, which according to earlier RBI communications would be looked through as it was transient in nature. Including HRA, CPI trajectory could move bps higher in FY18. We believe room for rate cut will only arise if 1) core inflation moves significantly lower than the current 5% and 2) global commodity prices move lower to keep headline inflation at 4%, both conditions looking extremely difficult at the current juncture. Exhibit 1: RBI Easing cycles A Premature end? Period Duration Start End Total Easing Yrs Policy Rate bps Feb'01 - Aug' yrs Oct'06 - Apr' yrs Mar'12 - May' yrs Jan'15 - Feb' yrs Source: RBI, ASKWA Research Exhibit 2: RBI s Inflation Trajectory Source: RBI Market Outlook: The fixed income markets have taken the policy negatively, with 10yr G-sec bond yield rising by over 30bps since policy. With a change in policy rate expectations (from 50bps cut to 0-25bps cut over the next 12 mths), 10 yr G-sec yield moving lower to 6% looks highly unlikely. We see 10yr G-sec yields likely to trade in a range of 6.5% at the lower end and 7% at the higher end. 2 P a g e 1 0 F e b r u a r y

3 However, yesterday s sharp move has caused some concern to investors. Investors should not panic, as our analysis of category returns of different debt schemes shows that 3yr returns for all debt categories at the day of demonetization (8 th Nov 2016) and as of yesterday are hardly different. Investors are still sitting on above 10% 3yr CAGR returns in these schemes. On 1yr returns, long term/dynamic/accrual funds are still giving higher returns compared to prior to demonetization period. Exhibit 3: Debt Oriented Category Returns Above 10% returns 8 th Feb th Feb th Dec th Nov yr 2yr 3yr 1yr 2yr 3yr 1yr 2yr 3yr 1yr 2yr 3yr Long Term Income Funds Gilt - Long Term Funds Gilt - Short Term Funds Dynamic Bond Funds Accrual Funds yr returns flat 1yr returns still higher despite sharp upward Source: ACE MF Exhibit 4: Money Market Category Returns Not much change since demonetization 8 th Feb th Feb th Dec th Nov mth 6mth 1yr 3mth 6mth 1yr 3mth 6mth 1yr 3mth 6mth 1yr Liquid Funds Ultra Short Term Funds Short Term Income Funds Source: ACE MF Short term funds have done well Our fixed income strategy is as follows: 1. Avoid fresh allocation to the duration trade. Investors should start looking at booking profits on their existing allocations to the longer end, as further incremental returns might be very measured, given the evolving policy orientation, and increased resultant volatility, 2. Look for opportunities at short to medium term of the yield curve as banking liquidity remains comfortable even in cyclically tight months, and is expected to remain easy till March Investors should pick strategies combining allocation to 1-4 years maturity basket, with exposure to AAA to A rated credits, and decent accrual yields. This will be available through select Debt mutual fund schemes. 3. Actively look at building yield in the debt portfolio: Credit accrual funds focusing on judicious mix of credit quality when targeting higher YTM; through exposure to companies with improving balance sheet and the likelihood of possible positive rating actions 3 year FMPs and preference shares with higher yields. Yield enhancement Structured Products We also see opportunities in select Bonds (AA to A) offering higher yields, given possibility of rating upgrades as the NPA cycle turns in the next 1-2yr, or for other reasons. 3 P a g e 1 0 F e b r u a r y

4 What is real neutral rate and why is it an important variable in RBI s monetary policy decision making? With RBI moving to an inflation targeting regime, real interest rate has become an important variable in determining the policy rate. What is a real interest rate? Real interest rate is the interest rate an individual gets after adjusting for retail inflation or CPI. In India, real interest rate (used by RBI) is derived by deducting inflation rate (CPI) from 1 yr government Treasury bill, which is in use since Prior to that, RBI did not have a specific benchmark. However, debate still exists on whether this is the most relevant benchmark, or is it the repo or policy rate, one-year bank fixed deposit rate, or the base rate against which banks lend to their customers. What is neutral real interest rate and what does it imply? Given monetary policy should be forward looking and with RBI targeting inflation rate between 2%-6%, RBI needs to assume a real interest rate in its policy formulations. A Neutral real rate of interest is the estimated level of real interest rates at which the economy is growing at potential while inflation is under control. The neutral real rate of interest indicates whether monetary policy at any point of time is too tight or too loose. It is one of the key variables, which is used in the famous Taylor Rule to assess the optimal monetary policy. What are the problems in determining the neutral real interest rate? Firstly, neutral real rate of interest is not directly observable and needs to be estimated statistically. Secondly, the rate changes over time, depending on the inflation target of the central bank, the state of the business cycle and estimates of potential output. What real interest rate is targeted by RBI? Under the previous RBI disposition under Dr. Raghuram Rajan, the objective was to keep real interest rates in the 1.5-2% range, in line with advanced nations and RBI s internal studies. However, in its October 2016 policy review, the new monetary policy committee (MPC) lowered the real rates range to 1.25%-1.5% citing declining neutral rates in advanced nations - many central banks have lowered the neutral rate over the last few years on account of global savings glut, growth stagnation and inflation running lower for long. Why real rates need to be positive in India? There are three important reasons why India should keep real rates positive and higher 1. Though inflation has declined from double digits, unlike advanced economies, India continues to have an inflationary rather than deflationary bias, driven by volatile food prices. High inflation and negative real rates was the primary reason for India s macroeconomic instability during India has a savings-investment gap instead of a savings glut, which advanced nations are facing. Financial savings have been falling diverting them to unproductive assets like gold or less productive sectors like the informal economy. 3. India is a current account deficit country relying on capital inflows to fund its growth. Thus, any sudden stop of capital could result in macroeconomic crises and collapse of growth. 4 P a g e 1 0 F e b r u a r y

5 Jan 02 Oct 02 Jul 03 Apr 04 Jan 05 Oct 05 Jul 06 Apr 07 Jan 08 Oct 08 Jul 09 Apr 10 Jan 11 Oct 11 Jul 12 Apr 13 Jan 14 Oct 14 Jul 15 Apr 16 Monetary Policy Review Exhibit 5: Real Rates % (Repo rate CPI) Real Rates Positive real rates since RBI targeted inflation have driven improvement in India s overall economic parameters. Negative real rates on account of high inflation and loose monetary policy was the primary reason for India s macroeconomic instability during Source: RBI, MOSPI, ASKWA Research Exhibit 6: Key Economic Parameters and relationship with real rates Real Rates CPI GDP Savings CAD % % YoY % YoY % GDP % GDP FY FY FY FY FY FY FY FY FY FY FY FY FY FY Source: RBI, MOSPI, ASKWA Research High real rates resulted in improvement in savings and lesser reliance on foreign flows and higher GDP growth. Negative real rates resulted in lower domestic savings and greater reliance on foreign flows to fund our external deficit driving growth lower. Disclaimer: This publication is made by ASK Wealth Advisors Pvt. Ltd (ASKWA) for private circulation only. The views expressed above are for information purposes only and should not be construed to be recommendations for any investments or products mentioned above or as financial/tax advice and/or as solicitation to buy or sell any investments/securities. The information mentioned in this publication is taken from various sources for which ASKWA does not assume any responsibility or liability and neither does guarantee its accuracy or adequacy. Investors are advised to take advice of experts before making any investment decisions. 5 P a g e 1 0 F e b r u a r y