Monetary Policy review: Familiar script with a surprise

The rate cut cycle may not begin before the second half of FY25

It’s a familiar script. There is no change in the Reserve Bank of India’s (RBI’s) policy rate. The repo remains at 6.5 per cent — for eight months in a row. The policy stance is also unchanged — withdrawal of accommodation as the transmission of the 250 basis points (bps) rate hike, between May 2022 and February 2023,  to bank lending and deposit rates is still incomplete. One bp is a hundredth of a percentage point.
 

The first decision is unanimous among the six-member monetary policy committee (MPC) of the Indian central bank; five MPC members are in favour of the second decision while one opposes it.
 

There is no change in the inflation as well growth estimate for the year.
 

So far, all actions — or, the lack of it — are on the expected line. But, there is one surprise that has rattled the bond market.

The RBI has announced plans to sell government bonds through open market operation (OMO) to manage liquidity, consistent with the stance of monetary policy. “The timing and quantum of such operations will depend on the evolving liquidity conditions.”
 

In September, the RBI sold bonds worth a few thousand crores. But that was done through screen-based trading in the secondary market. The OMO sale will be through auctions.
 

Somewhere in his statement, RBI Governor Shaktikanta Das has said: “It is a turning pitch and we will play our shots carefully.” Taking the cricket analogy further, the bond sale as a liquidity management tool is a googly for the market.
 

Unlike cash reserve ratio (CRR) — the money that commercial banks need to keep with the central bank on which they don’t earn any interest —OMO as a tool has a two-fold impact. It drains liquidity from the system and, at the same time, it also increases the supply of bonds as the RBI sells them to the banks. As a result of this, theoretically, it has a higher impact on the bond yield.
 

No wonder that reacting to this announcement, the 10-year bond yield jumped 12 basis points (bp) today – from 7.23 per cent to 7.35 per cent. Yield and prices of a bond move in opposite directions.
 

In the post-policy press conference, Das spoke about “killing one bird with one stone”. Without offending the bird lovers, the RBI, in reality, is trying to kill many birds with one stone. The use of OMO sale will push up the government bond yield and widen spread between US and Indian bond yields, which have been shrinking.
 

Historically, in such a phenomenon, foreign money flow into India slows down as the investors find US bonds more attractive and, consequently, the local currency comes under pressure. This is what has been happening in the past few weeks.
 

The RBI wants to address both the drop in foreign money flow and weakening rupee through this action, without being explicit.

The focus of this policy meeting has been on liquidity, which swelled following the return of the ~2000 currency notes to the banking system. The RBI has been conducting variable reverse repo rate auctions and foreign exchange swaps to drain liquidity. It also sucked out around ~1.1 trillion through incremental CRR, announced in the August policy. Half of this money is already back in the system and the rest will flow back tomorrow.
 

All these have led to the rise in the overnight call money rate to 6.75 per cent, higher than the 6.5 per cent policy rate — a 25 bps de facto rate hike.
 

Typically, banks borrow from the RBI’s marginal standing facility (MSF) window at 6.75 per cent when they need money and park excess liquidity at the standing deposit facility (SDF) window at 6.25 per cent. The call rate is now hovering around the 

MSF rate.
 

Overall, the hawkish policy statement is on the expected line. It reiterates that “the need of the hour is to remain vigilant and not give room to complacency” and that “high inflation is a major risk to macroeconomic stability and sustainable growth”. And hence, the monetary policy remains “resolutely focused on aligning inflation to the 4 per cent target on a durable basis”.
 

There is no change in the retail inflation estimate for FY24. It remains 5.4 per cent with a marginal upward revision for the second quarter — from 6.2 per cent to 6.4 per cent.
 

The real gross domestic product (GDP) growth projection for FY24 also remains unchanged — at 6.5 per cent with risks “evenly balanced”. The real GDP growth for the first quarter of FY25 is projected at 6.6 per cent.
 

The Monetary Policy Report, released along with the policy and the governor’s statement, estimates average retail inflation in FY25 at 4.5 per cent — in a range of 3.8-5.2 per cent — assuming a normal monsoon and no further exogenous or policy shocks. In the last quarter of the year, inflation is projected at 4.3 per cent.
 

Since the RBI is determined to bottle the inflation genie at 4 per cent for good, how long will we have to wait for the rate cut cycle to begin? Assuming a real rate (the difference between inflation and the policy rate/360-day treasury bill) of 1.25-1.5 percentage points, we will have to wait till the inflation comes down to 5-5.25 per cent for months. It may not happen before the second half of FY25. Of course, there could be many ifs and buts in between.

Writes Banker's Trust every Monday in Business Standard. 

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