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Monetary Policy and Financial Markets

05 August 20225 mins read by Angel One
Monetary Policy and Financial Markets
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The Monetary Policy announced by the RBI on October 04th was largely dovish on expected lines. The policy was announced in the background of 3 key triggers. Firstly, the overall CPI inflation had fallen sharply in the month of August 2016 to 5.05% from a level of 6.07% in July 2016. This was largely driven by a fall in food prices on the back of a good monsoon and better supply management. Secondly, growth has been tepid in the economy. Real GDP threatens to stay below the 8% mark for the next 2 financial years and the revival in capital cycle continues to be elusive. Thirdly, global markets which had seen a rush of hawkish adrenaline from the US Fed, seems to have postponed its rate hikes to either December 2016 or beyond. All these factors gave confidence to the RBI to adopt a more dovish approach.

But, more than the macro numbers it was the sustainability that was the key to the dovish approach of the RBI. The food inflation has come down by 300 bps in the last 1 month and that has been assisted by a strong monsoon, record Kharif output and improved supply management, especially of pulses. Secondly, on the growth front the worry used to be about transmission. That was not surprising as banks had only passed on 61 bps of rate cuts to the end customer, even as RBI had cut repo rates by 150 bps since January 2015. The expectation is that the MCLR will lead to better transmission of rate cuts to the end customer. Lastly, there is also confidence on the macro front. The RBI is confident of preventing a run on debt by FIIs due to a strong INR in the light of positive cues on the flows and deficit front.

Highlights of the monetary policy

  • The RBI cut repo rates by 25 basis points from 6.50% to 6.25% with immediate effect.
  • The cash reserve ratio (CRR) was left unchanged at 4% of net demand and time liabilities (NDTL) for banks
  • This reduction in repo rate effectively reduces the reverse rate to 5.75% and the bank rate to 6.75%.
  • The RBI has decided to continue its dual focus on giving out rate signals and liquidity management in the system

What exactly does the rate cut do for Indian markets?

The rate cut is a very important signal that the government is willing to go that extra mile for the sake of growth. As Dinesh Thakkar (Chairman & Managing Director, Angel One) put it succinctly, “A rate cut was very much required for the economy. Inflation support could open the gates for another 25 bps rate cut before the end of this fiscal year.”

The reduction of repo rates is also a positive signal from the RBI regarding its confidence that food inflation can be reined in. What this signal means is that the RBI is not only relying on good monsoons, which can be unpredictable, but also a statement on better supply side management as far as food is concerned. To quote Dinesh Thakkar, “Rising food prices was the prime culprit behind sticky CPI inflation. Softening in prices of fruits and vegetables on the back of a good monsoon has led to a positive and sustainable surprise for food prices.”

More importantly, the rate cut could have positive implications for the cost of funds for borrowers. Retail borrowers having floating rate loans with banks could see their EMIs or their tenures coming down as a result of lower rates. Lower rates also have a positive implication for equity markets. The cut in repo rates will result in lower interest rates and that will bring down the risk-free rate in the economy. This will bring down the cost of capital for Indian companies and thus discount their future cash flows at a lower rate. That can be really value accretive for Indian equity valuations.

What is the outlook for rates going ahead?

Two things are evident from the repo rate cut. Firstly, the rate cuts have been done with unanimity. All the 6 members of the Monetary Policy Committee (MPC) had favoured a rate cut in this policy. Secondly, the rate cuts appear to be sustainable as lower inflation may be here to stay. With the government addressing structural issues on the food supply front, lower food inflation may be here to stay. These factors could open the gates for another 25 bps rate cut later this fiscal. Of course, the RBI may want to have clarity on the US Fed’s approach to rates before taking a final call on the next rate cut. As Dinesh Thakkar sums it up, “With a good Kharif crop this year, pressure on food inflation is unlikely to emerge any time soon. With a marginal upside risk to inflation, G-Sec yields and cost of funds for banks will come down. This will enable better transmission, fixing the last block in the monetary jigsaw.”

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