RBI raised the repo rate by 25bps in its policy review today. The market was not expecting any rate hikes though there was an underlying apprehension on rate hikes post the release of the Dr. Urjit Patel Committee report on Revision and Strengthening of the Monetary Policy Framework in India. The ten year benchmark bond, the 8.83% 2023 bond saw yields rise by 25bps from lows of 8.50% to 8.75% post the release of the report.
Dr. Raghuram Rajan has formally embraced the report in his policy stance. The report sets an objective for the CPI (Consumer Price Index) to reach levels of 8% by January 2015 and levels of 6% by January 2016. CPI is trending at levels of 9.87% as of December 2013.
The repo rate hike of 25bps was consistent with the adoption of the inflation target of 8% for CPI over the next one year. Given that CPI is ruling at 9.87% levels, a rate hike is not surprising if the RBI is determined to bring down inflation. However, RBI has guided that it will not hike rates further unless there is a spike in inflation expectations. Markets will start factoring in status quo on repo rates for the whole of 2014 if CPI behaves as per RBI’s expectations.
A sharp fall in CPI to well below 8% levels could trigger prospects of a rate cut but that is not seen on the horizon at present.
RBI kept CRR (Cash Reserve Ratio) unchanged and left the Repo- Reverse Repo – MSF corridor at 100bps. RBI would focus on liquidity management going forward and would ensure sufficient system liquidity through repos, term repos and selective bond purchase auctions.
What does this formal inflation targeting stance of the RBI mean for the bond market? In the long term it is positive as inflation expectations will come down in the economy. RBI would adopt counter cyclical policy if the government adopts inflationary policies of borrowing and spending. If the government does fall in line with the RBI’s inflation targeting approach, it is even better for the economy as falling inflation expectations strengthen the framework of the economy.
Bond market’s immediate reaction to the rate hike was muted as yields had already backed up by 25bps from lows. In the long term, falling inflation expectations are positive for bond yields and bond and bond fund investors should stay positive on bonds.
In the short to medium term, volatility could increase if the CPI that is heavily weighted towards food articles with close to 50% weight shows high volatility on the back of volatile food prices. Food inflation has been trending at high double digit levels while non food manufacturing inflation has been trending at around 8% levels over the last one year.
RBI’s inflation targeting should be consistent over the long term. Any move away from the inflation target would mean question marks on the central bank’s independence and bond markets would get nervous and confused. Dr Rajan should be firm on RBI’s policies that are aimed at lowering long term inflation expectations.
The formal adoption of an inflation target is positive as it will give markets a single point focus and would be able to judge RBI’s actions based on consensus inflation estimates.
Going forward, status quo on repo rates and focus on liquidity is likely to keep bond yields from moving much higher from current levels of 8.75% on the ten year government bond. The INR too will benefit from stable rates while equities will move on earnings and global flows.