RBI Monetary Policy Reaction: Quantum AMC

8 Feb 2024 , 05:14 PM

The RBI delivered another do-nothing policy. There was some disappointment for the market as a section a market including us was expecting at least a stance change from ‘withdrawal of accommodation’ to ‘neutral.’  In justification of ‘withdrawal of accommodation’ stance, the governor linked the stance to the RBI’s inflation target and policy transmission. The governor highlighted that CPI inflation is still above the RBI’s 4% goal and the transmission of past monetary policy actions is still incomplete in the credit market. This is different from RBI’s earlier assessments which had linked the stance to level of real rates and liquidity condition.

On inflation, the RBI seems more worried about volatile food prices and uncertain food inflation outlook. The RBI estimates CPI inflation to fall to average of 4.5% in FY25 provided a normal monsoon. Based on the RBI’s assessment of inflation and its new interpretation of the policy stance, any rate cut before August-2024 policy looks unlikely. By August, we will have a fair understanding of the monsoon progress and sowing trends to make reasonable assessment of the food inflation in FY25.        

There was an expectation that the RBI will announce some liquidity infusion measures to deal with the recent tightness in the banking system. However, the RBI seems comfortable with the overall liquidity condition and doesn’t see any need to infuse durable liquidity at this stage. Much of the liquidity tightness over the last 3-4 months was contributed by slow pace of government spending. The banking system liquidity is in deficit of around Rs. 1.4 trillion while the government’s surplus cash balance is around Rs. 3 trillion. As government spending pickup this amount will get added to the banking system liquidity. Thus, on net basis, the core liquidity is in surplus.

Only issue with the RBI’s liquidity assessment is that the government has been maintaining high cash balances on a persistent basis. In the 10 months of the FY24, government cash balance has averaged above Rs. 2 trillion. Extrapolating this trend into future implies that banking system liquidity will continue to be in deficit. Moreover, cash withdrawals tend to pick up between February to May period. Based on historical trend, around Rs. 2 trillion might be withdrawn from the banking system over the next four months adding further to the liquidity deficit. Thus, we expect liquidity condition to tighten significantly over the coming months.

We expect short term money market rates to remain elevated due to tight liquidity environment. This should be supportive for liquid funds that rely on interest accruals on short term debt instruments. For the bond market, outlook remains positive supported by falling inflation trend, possibility of rate cuts, global bond index inclusion and favorable demand supply mix.

Investors with 2-3 years investment horizon can consider dynamic bond funds to potentially benefit from the falling bond yields. Conservative investors with shorter holding period should stick with liquid funds.