RBI Policy (September 16, 2011)

The RBI hiked repo rate by 25 bps today to 8.25%. As a result reverse repo rate has been automatically raised to 7.25%, while rate under Marginal Standing Facility (MSF) has also been automatically raised to 9.25%. CRR, SLR have been kept unchanged. The move was in line with consensus market expectation. Market price action post the move is very muted given that the action was widely expected.

RBI’s View Point
The tone of the policy seems to indicate that the RBI is broadly comfortable with the pace of slowdown as underway currently. It notes that the global macro outlook has worsened considerably and lead indicators suggest there will be further moderation in economic activity in Q3. This will impact India ’s export performance which has been strong recently. Lead indicators of the domestic economy are also suggesting moderation. Hence, the RBI acknowledges downside risks to its 8% growth projection made in July.

However, inflation continues to be high and sticky and inflationary expectations as well remain outside the RBI’s comfort zone. The fresh rise in non-food manufacturing inflation in August also suggests demand pressures. Furthermore, there is still an element of ‘suppressed’ inflation in form of incomplete pass through of global oil prices into domestic prices as well as possible hike in administered electricity prices. Food inflation also is no longer a temporary phenomenon as it reflects structural demand supply imbalances.

In terms of forward guidance, the RBI notes that stance will be influenced b signs of downward movement in inflation trajectory, and implications of global developments. It notes also that the cumulative impact of policy actions should now be increasingly felt in further moderation in demand and reversal of inflation trajectory towards later part of 2011 – 12.

Assessment
Given the stickiness of inflation at elevated levels, it was unlikely that the RBI would tone down its stance significantly. Even so, there seems to be general comfort with the way growth is already slowing, and some optimism that demand moderation will continue and would also contribute to easing of inflationary pressures.

Importantly, the inflation trajectory from here is very likely down (due to base effect, falling demand momentum, etc) barring a major commodity uptick. Whereas, implications of global development on local growth are also unlikely to turn positive. Hence, a plain reading of triggers influencing RBI’s future stance seems to suggest that its policy rate cycle may have topped out provided there is no further shocks from commodity price adjustments. The outright voices of disagreement on further rate hikes from influential quarters of the government also seems to suggest as much.

Implications
The last 125bps of rate hikes have been almost completely absorbed by short end rates (benchmark 1 year CD) owing to continued falling credit to deposit ratio of banks. This is a point that we have been making for some time and forms the basis of our product recommendation of the IDFC SSIF- ST . Today’s hike has also done little to change this view. While credit growth may improve going into busy season from October, deposit base continues to grow healthily and incremental credit to deposit ratio is unlikely to be impacted adversely. This should support an eventual curve steepening over the next 6 – 8 months thereby benefitting the short term fund trade.