Low inflation, less hawkish tone of RBI hints at possible rate cut ahead
The revised inflation trajectory which is appreciably lower than the earlier assessment made in April 2017 coupled with the less hawkish tone of the policy statement seem to suggest a possibility of rate cut in the coming quarters.
The volatility in the Indian bond market continues with yields on the prevailing benchmark 10-year government securities (G-sec) declining by 40 bps during last one month to 6.51 percent as on June 12, 2017. The release of new Wholesale Price Index (WPI) inflation series with 2011-12 as the base year, which pegged inflation levels much lower than the estimates of earlier series triggered a rally in the bond markets, as yields on the bonds declined by 25-30 bps within a week of release of new inflation series.
The timely progress of monsoon and the headline Consumer Price Index (CPI) inflation remaining below the medium term target of 4 percent since November 2016 also prompted the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) to revise its inflation targets downwards in its monetary policy meeting of June 2017 leading to further decline in G-sec yields. The inflation targets have been revised downwards by MPC to 2.0-3.5 percent for H1 FY2018 and 3.5-4.5 percent for H2FY2018 in June 2017 as against 4.0-4.5 percent and 4.5-5.0 percent respectively in April 2017.
The revised inflation trajectory which is appreciably lower than the earlier assessment made in April 2017 coupled with the less hawkish tone of the policy statement seem to suggest a possibility of rate cut in the coming quarters. The downward revision in the inflation estimates further added legs to the bond market rally with yields on 10-year G-sec declining by 8-10 bps on the day of policy announcement itself.
Despite downward revision in the inflation forecasts during June 2017, the MPC continued to maintain its “neutral” stance on the monetary policy to see a more sustained reading on the softer inflation levels and left the repo rate unchanged at 6.25 percent.
While the MPC retained the neutral stance of monetary policy, for the first time since the inception of the MPC, the decision was not unanimous. The minutes of the June 2017 MPC meeting are awaited for the assessment of the individual members on the extent of concern posed by various inflation risks. The tone of the minutes would provide cues regarding how soon a policy rate cut or change in stance to accommodative may be expected, which would determine whether bond yields ease further after the dip seen last week. With CPI inflation for May 2017 coming as low as 2.18 percent, the chances are that average inflation for H1 FY2018 is likely to remain well within RBI’s inflation estimate band, which may support the change in the stance of MPC from neutral to accommodative in the upcoming monetary policy itself.
The transmission of policy actions has been quite fast in the debt capital markets but transmission in lending rates by the banks continue to lag the cuts in the policy rates as well as the deposit rates since January 2015. As against the 175 bps cut in the policy rates by RBI, the banks have cumulatively cut the deposit rates by 215 bps while the lending rates have been slashed by 145 bps over the same period with a large part of the lending rate cuts being affected after the note ban.
The median 1-year deposit rate for the banks stands at 6.85 percent as compared to 8.4 percent interest rates being offered on some of the small saving deposit schemes, accordingly, the ability of the banks to affect major cuts in deposit rates remains limited despite the surplus systemic liquidity.
With better rate transmission in the debt capital markets aided by the strong flows into key investor segments such as mutual funds and insurance, we expect the stronger entities to be able to raise funds at finer rates compared to the recent past.
Given the weak credit growth, the banks may be cautious on further cut in their benchmark lending rates even as they lose out on incremental business to debt capital markets unless the systemic credit demand revives and supply side issues in terms of ability to extend loans amid weak capital levels are adequately addressed. The cut in the lending rates will largely be governed by passing on some of the benefit to the borrowers as their own cost of funds gets repriced. At 5.4 percent, the cost of funds for banks during Q4 FY2017 in nearing all-time low of 5.25 percent during Q1 FY2011 reflecting limited scope of further decline in cost of funds unless supported by further cut in deposits rates.
However the weak capital profile of banks and the continued asset quality pressures may restrict bank from aggressive cuts in lending rates though they may evaluate lower lending rates for certain asset classes such as retail loans given the lower capital requirements and relatively better asset quality. Retail borrowers can benefit from the recent reduction in risk weights and standard asset provisioning for new individual home loans in form of lower rates or higher loan eligibility.(The author is Group Head – Financial Sector Ratings - ICRA ratings agency)