Monetary Policy Review Dec 2023: No action, none needed

NEW DELHI: The Monetary Policy Review (MPC) kept repo rate and stance unchanged in the policy review as was widely expected. Unlike recent previous policy reviews, and much to the relief of the market, there was lesser to read under the hood this time around as well.

The real GDP forecast for the current financial year has been raised by 50 bps to 7%. This reflects not just a stronger than expected Q2 but also some nudging up of growth for the rest of the year as well. RBI expects growth momentum to largely continue into the next year, largely reflecting domestic strengths even as the global outlook remains more two-sided. Somewhat surprisingly, despite an ongoing food shock leading to expectations of higher next two readings, RBI has left its near term CPI forecast unchanged. The addition to FY25 forecasts are largely as per market expectations.

The policy emphasis remains on an active disinflationary stance in pursuit of the 4% target sustainably. The primary impediments to this are in the form of persistent food shocks that have potential to derail inflationary expectations. However, the comfort thus far is that this isn’t as yet seen in inflation expectation surveys of households and core inflation remains well behaved. Additionally, a host of global commodity prices have cooled off and government supply measures remain proactive locally.

Of most relevance to the bond market was the lack of any commitment on future OMO bond sales. The Governor acknowledged that owing to factors like higher currency leakage, government cash balances, and RBI operations, system liquidity tightened significantly compared with what RBI had assessed in October and hence the need for OMOs hadn’t arisen yet. That said, RBI expects liquidity conditions to ease going forward on government spending.

Also the commitment to nimbly manage liquidity remains, thereby not entirely taking away the threat of OMO sales. On our part we continue to see core liquidity surplus diminishing to Rs 1 lakh crores or lower by the end of the financial year as the January-March quarter sees heavy leakage of currency, even considering that the y-o-y growth rate of this variable is quite muted. The calculation on core liquidity assumes no meaningful capital inflow led incremental liquidity creation. Thus we don’t see threat of any meaningful OMO sales, even as sporadic amounts cannot be entirely ruled out.

An important point to note also is that RBI seems happy with the pace at which its balance sheet has moderated as a percentage of GDP, from 28.6% in FY 21 to 21.6% currently. Thus apart from near term liquidity considerations as discussed above, there isn’t any need for active asset sale to manage balance sheet size for macro-economic reasons.

Takeaways

Even as repo rate has been on hold for most of the year, RBI has nevertheless re-commenced incremental tightening over the past few months. One, there has been a clear higher tolerance exhibited recently with overnight rates at MSF rather than at repo. This has been persistent enough for the market to now price the money market curve starting at 6.75% rather than at 6.5%. Two, while recent risk weight hike was to mitigate potential risk buildup in a certain section of credit, the effect will nevertheless be to make consumer leverage somewhat more expensive. Ceteris paribus, this further takes away the need to do anything more on monetary policy even as all options are still kept on the table as should be for any prudent central bank. Thus it is quite reasonable, in our view, to conclude that the rate cycle has peaked.

The next question is: given a robust assessment of FY25 GDP forecast and CPI not coming down to 4% sustainably even in that year, where is the scope for monetary easing? In answering this we draw inspiration (not actual quotes) from the Governor’s own response to a question in the post policy media conference. The world is a very uncertain place and hence one shouldn’t be too deterministic about the future.

To elaborate further (our own), global growth will likely slow further going ahead as the US finally slows. While our domestic drivers are strong, government spending is unlikely to remain at the pace it has been so far. Consumer leverage will likely slow down as well. And if the world is a more uncertain place, then a broad based private capex cycle may also get pushed back. Thus it is possible that growth turns out to be slower than currently forecasted. Put another way, as with other parts of the world, India too may enter a period of below trend growth. This may open up space for some monetary easing.

A connected point is this: there is a view in the market that RBI will neutralise most of the bond inflow related to index inclusion with OMO sales of its own. However, it is probable that the monetary policy stance is less tight by then. Consequently, the tolerance for the ‘excess’ liquidity created may be greater by then thereby not leading to one to one matching with OMO sales. An additional point we have made before is also that annual currency leakage is of the order of INR equivalent of USD 30 billion.

Given that the new financial year may start with relatively low levels of core liquidity, this may be an additional point to not try and neutralise all incoming flows via bond sales. A third point has been provided today by the Governor and referred to above: the central bank has no discomfort with the size of its balance sheet as a percentage of GDP. Thus it may be quite comfortable allowing its balance sheet size to rise with growth in GDP.

All told, we find bond valuations are attractive and the yield curve is reasonably positive sloping even at peak policy rates. Additionally there are 3 reasons why we think it is time for investors to seriously consider extending bond allocations: A likely global cycle peak, India’s benign current account dynamics arguing for stable long term rates, Probable greater internationalisation of interest in Indian bonds with the proximate trigger being the index inclusion.

In our view, it is time to elongate portfolio maturities, especially considering very short end allocations done over the past year or so given high rate volatility and attractive bank deposit rates. One way to hedge upcoming reinvestment risks is to increase maturity on new investments being made today. We retain an overweight 14-year government bond stance in our actively managed bond and gilt funds. We also think that the recent widening of credit spreads will likely continue thereby making quality fixed income the most attractive on a risk adjusted basis.