Keeping the repo rate (8%) and CRR (4.75%) unchanged, RBI surprised the street negatively which was expecting at least 25bps reduction in both. The central bank’s inaction with respect to policy rate could be attributed to the frontloading of repo cut (higher than expected 50bps) in April policy. No change in CRR was disappointing given the prolonged tightness in system liquidity. The central bank is likely to use OMOs as and when warranted to contain liquidity pressures. RBI reiterated that government policy action and fiscal consolidation were more critical than monetary measures to improve the growth-inflation situation.
Large 50bps repo cut in April remains to be transmitted
With inherent inertia in deposits rates on account of weak mobilization, tight liquidity and inflationary environment, many banks have been averse to cut lending rates. Not surprisingly, monetary transmission of the 50bps repo rate cut in April was weak. Recent meetings with few banks indicate additional lag in transmission of monetary easing.
Inflation above comfort levels and risks remain on the upside
December headline (7.6%) and core (4.9%) inflation were slightly higher than expectation. CPI for May came in at 10.3% having increased from 7.7% in January. Further risks to inflation are on the upside with suppressed inflation in fuel, likely increase in power tariffs, weak currency, recent steep increase (16-53%) in Kharif MSPs, unsatisfactory start to the south-west monsoon and significant upward revision in the provisional inflation data of March.
Liquidity to remain tight
Liquidity in the AMJ quarter has been tight but the deficit has been lower than JFM quarter. CRR cut of 125bps and substantial OMOs have eased situation sequentially. However, short term rates (3/6m CP/CDs) have corrected only marginally (30-40bps) reflecting continued deficit expectations. Weak deposits mobilization and high government borrowings would continue to act as overhang on liquidity.
Policy outlook hinged on inflation expectations
As policy guidance, RBI mentioned that further rate action would be a function of subsiding inflation risks. Therefore, outcome of the next policy on July 31st would largely hinge on May WPI and June CPI data which are unlikely to indicate any trend reversal in our view. Rate cut in July now carries a significantly lower probability.
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