Inflation worries play on RBI's mind, dampen mood of bond market

Higher inflation projection rules out any rate cut possibility in the first half of FY22; bond yield jumps

Reserve Bank of India governor walked a tightrope on Friday as the six-member monetary policy committee (MPC) kept the interest rate unchanged for the fourth consecutive policy review while maintaining the accommodative stance despite projecting higher inflation in the first half of the next financial year. Though the status quo was in line with market expectation, a section of the market was also expecting a rate cut after the Union Budget presented earlier pushed the growth pedal with greater resolve.

Governor Shaktikanta Das sounded as dovish as possible when he said the accommodative stance of the monetary policy will be maintained as long as necessary to revive growth while acknowledging that growth outlook had improved significantly.

“The outlook on growth has improved significantly, with positive growth impulses becoming more broad-based, and the rollout of the vaccination programme in the country auguring well for the end of the pandemic Given that inflation has returned within the tolerance band, the MPC judged that the need of the hour is to continue to support growth, assuage the impact of Covid-19 and return the economy to a higher growth trajectory,” Das said in a statement while announcing the decision of the MPC.

RBI has projected real GDP growth of 10.5 per cent in 2021-22 – in the range of 26.2 to 8.3 per cent in H1 and 6.0 per cent in Q3. The economic survey released last week projected FY22 real GDP growth at 11%.

The higher inflation projection, at 5-5.2% for the first half of FY22, which was higher than the December policy projection of 4.6%, dampened the mood of the bond market sentiments. The yield on the 10-year government bond jumped as much as 8 bps to 6.15% after the policy announcement. (100 bps = 1 percentage point). This virtually rules out any possibility of a rate cut till September unless inflation outlook changes drastically.

The inflation projection for the third quarter is 4.3 per cent.

“I think some people were expecting a rate cut. The yields have shot up because there was no rate cut. Even the decision is unanimous,” said Anagha Deodhar, chief economist, ICICI Securities.

“The inflation trajectory that the RBI has given is also slightly higher than what some people were expecting. If you look at the headline inflation then there is no rate cut in the near term,” she told Business Standard.

Bond yields started to head north and crossed 6% after the Union budget was announced earlier this week due to a large borrowing programme for FY22, at Rs 12.05 trillion. To make things worse for the bond market, the government announced an additional borrowing of Rs 80,000 crore in the current financial year.

As the yields spiked, the market was expecting a few measures like a schedule for open market operations (OMO) for purchasing government bonds and a hike in bank’s held to maturity (HTM) limit.

“… market players were disappointed as they expected specific measures like increase in HTM limits, OMO calendar,” Murthy Nagarajan, head-Fixed Income, Tata Mutual Fund.

“How the market behaves will depend upon how RBI follows with its statement. RBI governor has stated the CRR hike would allow them to undertake more measures to see to it that the borrowing programme goes on smoothly. This may be a tussle between the bond markets traders and RBI, if RBI does not do convincing measures, traders would take the yield higher,” he added.

On September 1, 2020, RBI increased the limits under Held to Maturity (HTM) category from 19.5 per cent to 22 per cent of net demand and time liabilities (NDTL) in respect of statutory liquidity ratio (SLR) eligible securities acquired on or after September 1, 2020, up to March 31, 2021. This dispensation was made available up to March 31, 2022. On Friday, RBI said that in order to provide certainty to the market participants in the context of the borrowing programme of the centre and states for 2021-22, it has now been decided to extend the dispensation of enhanced HTM of 22 per cent up to March 31, 2023 to include securities acquired between April 1, 2021 and March 31, 2022.

There was no announcement of OMO till the time of publishing the story, though the market expects liquidity support to continue despite the cash reserve ratio which was lowered last year, would be rolled back in a phased manner. RBI governor emphasised that the stance of liquidity management continues to be accommodative and completely in consonance with the stance of monetary policy.

“The art of managing ‘RBI liquexit’ required words as much as action,” said Aurodeep Nandi, India Economist, Nomura.

“On both, the RBI largely lived up to expectations, and in some aspects exceeded it. The RBI clearly communicated that it doesn’t intend to yank away the liquidity carpet in a way that topples the vases of growth recovery and fiscal financing resting on it,” he said adding the status quo in policy rates and dovish policy stance correctly takes into cognizance the current growth-inflation dynamics.