RBI should stick to its policy and forecasts and not react on near term economic data. Markets believe that RBI knows more than what is published and a reactive policy takes away that belief and the central bank policy pass through will then become ineffective.
RBI in the last one year has see sawed in its policy, leaving market participants confused on its actions. In October 2016, RBI cut the repo rate by 25bps to bring it down to levels of 6.25% and cited that real rates of interest at around 1.25% is required for India’s growth economy. CPI inflation printed at 4.4% for September 2016 while core CPI, stripped of food and fuel was at around 5% levels. RBI kept policy accommodative to spur economic growth.
Demonetization was announced in November 2016 and it was forecast to lower economic growth. However, RBI maintained status quo in its policy in December 2016 and in February 2017, the central bank threw a complete surprise to markets by changing policy stance from accommodative to neutral. CPI inflation has printed continuously lower since September 2016 and was at levels of 3.28% as of September 2017.
RBI cited sticky core inflation at levels of 5% for changing stance from accommodative to neutral. However, core inflation then fell to levels of 4% in June 2017 and RBI cut the repo rate by 25bps in August 2017 on the back of fall in core inflation.
In October 2017, RBI maintained its neutral stance and upped it forecast for CPI inflation for 2nd half of fiscal 2017-18 from 4% to 4.5% to 4.2% to 4.6% and this effectively sent signals to the markets that rates cuts are not on the horizon. Core inflation too ticked up over 4%. Read our RBI October Policy Analysis for Policy Details.
Economic growth meanwhile felt the effects of both demonetization and GST implementation and fell to 5.7% in the 1st quarter of fiscal 2017-18 from 6.1% seen in the 4th quarter of fiscal 2016-17. GDP growth for full year of fiscal 2016-17 was 7.1%. RBI revised its GDP growth forecast for fiscal 2017-18 from over 7% levels to levels of 6.7% in its October policy.
Raising inflation forecast in a period of just three months and lowering GDP growth forecasts sends out highly negative signals to the market. In a matter of one year, RBI’s policy tone has changed from dovish to hawkish twice.
In all the policy moves, RBI has been fire fighting demonetization impact on currency in circulation and has also been accumulating fx reserves both in the spot and forward markets. Liquidity will stay high in the system, which is making liquidity management the key objective. Read our Liquidity Cheat Sheet for Liquidity Outlook.
10 year government bond yield has seen movements of 30bps down and up on the back of RBI policy statements and actions. Markets are unwilling to take any directional bets give RBI’s see-sawing.