Oct 04, 2016 11:09 AM IST | Source: CNBC-TV18

RBI Policy: Rate cut to be in line with inflation target, say experts

RBI is operating in an inflation targeting framework and they will decide on rate cuts with an eye on their 4-percent inflation target, says Jahangir Aziz, Asia Economic Research, JPMorgan.

All eyes will be on the interest rate decision Tuesday by the newly constituted Monetary Policy Committee (MPC) headed by RBI Governor Urjit Patel.

In an interview to CNBC-TV18 Jahangir Aziz, Asia Economic Research at JP Morgan, Willem Buiter, Global Chief Economist at Citi and Deepali Bhargava, Economist at Credit Suisse talk about their expectation from the MPC.

Aziz is of the view that RBI is operating in an inflation targeting framework and they will decide on rate cuts with an eye on their 4-percent inflation target. However, the house will be keenly watching for any change in language in terms of trajectory for inflation and growth.

Buiter who was a teacher to the RBI governor Urjit Patel does not expect him to be either hawkish or dovish because according to him, Patel has been the principal architect of flexible inflation targeting that India has adopted and so, expects him to remain true to that arrangement.

Bhargava says she is not expecting RBI to move today but will keenly watch the commentary from different members of the MPC on their outlook on real rates, transmission along with inflation target. However if not today, then December rate cut is given.

On the liquidity front, Buiter says usually Central Banks like a little bit of margin on liquidity front - they don’t like to ration liquidity, neither drown banking sector in liquidity. “Interest rates, liquidity management and balance sheet management by the Central Bank have to go hand-in-hand,” says Buiter, adding, this will be done cautiously but determinately in pursuit of this 4 percent inflation in the medium-term by RBI.

The rupee currently is trading strong and bond yields are below 7 percent.

Aziz says the bond markets strongly believe the rate cut cycle would continue into the first quarter of next year. However, he is not worried about the bond yields because he expects the large open market operations to continue going forward.

However, rupee, according to Aziz is open to all sorts of external events – like US elections, geopolitical uncertainties etc and therefore, difficult to say where it is headed.

Below is the verbatim transcript of Jahangir Aziz, Willem Buiter and Deepali Bhargava's interview to Latha Venkatesh and Anuj Singhal on CNBC-TV18.

Latha: You know Urjit very well, you have taught him, what is your sense, is Urjit likely to be a textbook economist, faithful to the inflation reading and maybe a Volcker in Indian soil, hawkish you think?

Buiter: He has been the principal architect of the flexible inflation targeting arrangement that India has adopted which means that you take the inflation target seriously but at the same time concerned about effects of monetary policy on the real economy. I think he will with the committee which of course though jointly with him takes a decision, he will strike a balance and I think I would neither regard him as hawkish or dovish, I will just regard him as true to the arrangement that he himself has been the father of.

Anuj: Do you think the data supports a rate cut, the market is pricing in a pause and some might say that some part of the market might be already pricing in a cut but do you think the data supports at least 25 bps rate cut?

Aziz: I am going to basically repeat what William Buiter said, this is inflation targeting framework. In inflation targeting framework, you just don’t react only to pass inflation, you have to form a view of what inflation will be 12 and 18 months ahead. In inflation targeting framework, the Reserve Bank of India (RBI) is actually accountable for 4 percent. It is not just cutting rates when inflation goes down or raising rates when inflation goes up. So I think all boils down to MPC.

Look at the fall in food inflation, look at the fall in headline prices, core inflation hasn’t budged very much for a very long time and to look at this decline in inflation, look at what might happen in the next two-three months where we do expect headline inflation to continue to fall and make a judgement call whether or not this decline in inflation, where does it stay above 12-18 months ahead, 4 percent target.

If they believe that this decline in inflation will lead to the 4 percent target been met reasonably easily, they will cut rates otherwise they won\\'t.

Latha: The transmission of policy rates has happened not because of the RBI cutting rates by about 150 basis points (bps) up until last April but because starting April they also brought in more liquidity, banks searching for reserves to meet their reserve requirements, now found more liquidity in the banking system, in fact on several occasions, the RBI has absorbed liquidity, there is more cash than the banks need, do you think that will be contravene Patel\\'s long held views, easy and austere economist true to the theory and therefore my dislike too much of liquidity?

Buiter: I think Central Banks like a little bit of margin around normal liquidity that they don’t like to either ration or drown the banking sector in liquidity. The previous and extremely tight liquidity conditions has now been corrected. I don’t think there is any strong reason for moving to the other side of balance and creating excessive liquidity. I think interest rates and liquidity management and the balance sheet management by the Central Bank has to go hand in hand and it will be done cautiously but determinately in pursuit of this 12 percent deflation target in the medium-term.

Latha: Should the Reserve Bank of India (RBI) be terribly worried about the global backdrop? They get one monetary policy chance today, the next policy date is December 6, just about a week before the FOMC meeting where it is widely expected that a rate hike might come. Therefore do you think the RBI will be better placed to cut now rather than December because ahead of Fed rate hikes normally emerging markets are in turmoil?

Buiter: What the Fed will do in December depends on the outcome of the American elections. At the moment the best case is 64 percent in favour of Hillary Clinton winning the election in which case there will be a rate increase and 40 percent for likelihood of Donald Trump winning the election in which case there won’t be a rate increase. The nice thing about interest rate increases is that it will be quite easy to reverse.

So, I think the bank should and probably will make its best guess based on current information about what the future path of global interest rate, not just in the US, also in Japan and Europe is going to be. Take the appropriate action there, and surprise us, change course. There is nothing wrong with changing one’s actions when the exogenous environment changes. Change in monetary view when the facts change is sign of common sense, not of frivolity.

Anuj: What about the money market now, we have seen of course the bond yields below 7 percent, currency market has been strong, what from here?

Aziz: What is happening in the bond market for example is a combination of two things. One is that it actually believes very strongly that there will be rate cuts down the road, even if it is just a 25 basis points today, they do expect the rate cut cycle to continue at least into the first quarter of next year. More importantly there has been a massive amount of open market operations that has been done by the RBI which has brought down the yields.

So, looking forward, my sense is that you are going to continue to see very large open market operations continue especially in the period of November when we have the outflows related to Foreign Currency Non-Resident Account (FCNR). So, I am not that worried about the bond yields simply because it looks as if that among the many changes or many differences between this year’s operations of monetary policy and last year. Last year we saw very limited amount of global market operations being done and that has been more or less reversed this year where we do expect to see significant open market operations going through which should keep the 10-year bond yields down.

The rupee is a completely different matter and the rupee is open to all sorts of exogenous and external events including what happens in the US elections, what happens to geopolitical uncertainties. So, it is difficult to say at this point in time which way the rupee is heading because there is little clarity on both these external drivers of the rupee at this point in time.

Latha: I wanted to ask your reaction to the overnight developments in the crude market with Iran actually asking Venezuela to participate as a non-OPEC member in supporting crude prices. Have we got something different coming in the form of a cartelised crude price and therefore probably a different inflation trajectory for the next 12 months?

Buiter: It is intriguing but, OPEC, there has been a lot of talk and very little action in terms of concerted agreement on both, common quota and the detailed division of this quota over individual member stakes. So, my best guess at this point is that it is unlikely that either Iran or Venezuela will agree to meaningful cuts in production.

Venezuela is an totally oil dependent economy and Iran is more diversified but for historical reasons is producing below capacity and wants to get back to where it was, where it would have been if it hasn’t been for the embargo and for the Venezuela sanctions. So, this is interesting, it shows that there is interest in OPEC in constraining production but no evidence of any willingness of individual countries to play by the rules of commonly and forced cartel. So, I think this is going to go nowhere and the market will wake up to that before too long.

Latha: Finally, what would you look out for? Today we are going to get a monetary policy report. We will get a monetary policy statement which I assume, will look more like the FOMC statement rather than the eight page statements that we used to get from the Reserve Bank earlier. And of course, we will have the press conference where there will be statements on liquidity and dollar buying and bond buying and non-performing loans (NPL), bad loans. What will you really look out for?

Aziz: I will look at the change in language. At the beginning of the programme, we talked about how different economists have said that, just a few months back, the RBI was looking at high inflation risks than lower inflation risk. So, two things I would look at. Are they changing their view on inflation? In particular, do they look at the next 2-3 months of drop in inflation and say that this is all temporary and that core inflation is still very high and inflation is going to be back up to above 5 percent, let us say in the middle of next year or even earlier. So, it is a trajectory of how they view inflation looking forward.

And definitely on growth. How are they viewing what is happening in private investment, what is happening in the export sector to figure out what the growth trajectory is. Those are the two things that I would definitely look towards in terms of change in language, in this particular monetary policy statement. After that, of course, we will wait for the three independent MPC members’ views on what decisions and how they came to their decisions.

Latha: Should we worry about global markets. We have seen, as we have been seeing for a long time now, yields at historic lows and equity valuations at all-time highs indicating growth. There seems to be a contradiction here. Should we prepare for some kind of a meltdown or do you think we will manage this contradiction?

Buiter: A meltdown may be too much, but it does seem that even though very low yields, risk free rates, other things being equal, would boost equity valuations. Equity valuations, especially in a fast economy, not so much in emerging markets, are over estimating the shoot to growth of corporate earnings. So, a correction is likely. But, India is as well-positioned as any emerging market to handle this. It is well managed macro-economically and indeed, it is at some risk of becoming a safe haven emerging market which it will be a mixed blessing, but quite ironic in view of not so recent history.

Latha: What are you betting today and more importantly, what is the difference, because it is going to be a committee?

Bhargava: We are not looking for any rate cut today and it will be interesting to know how different the new players in the MPC are thinking about various variables, not just inflation target but more importantly, I would tend to think on real rates and transmission. But, in my view, October or a December rate cut is a given. What will be more important is how the commentary works, how the entire monetary policy mechanism works, how they communicate, how they descend, etc. So, that will be more interesting to see. Today we will just see a monetary policy report from what I understand and the minutes will follow, hopefully from what we have learned from what we were told earlier. So, if monetary policy minutes actually follow through on the 14th day, how transparent they are. So, that will bind most of the committee members to really abide by what they believe. So, a lot of new changes today, but primarily looking for no change on the rate side.

Latha: Do you think if the vote came in as 4:2 in favour of a cut or a 5:1 in favour of a hold, because it is not an unambiguous statement because there is a vote, the reception of the market will be any different?

Bhargava: There will be a little bit of confusion in the sense of if it is more dovish than what people had expected, a 5:1 in favour of a rate cut will clearly be very dovish and people will start factoring in aggressive pace of rate cut because we need to understand that currently, investors are pricing in anything from between 25-100 basis points. So, the expectations from monetary policy are very diverge. So, if you see a very strong vote in favour of a particular outcome, I do think there will be a market move, especially on the bond side.

Latha: What are you factoring in, in terms of bond yields? What is your base case and what can be the best case?

Bhargava: Even if there is no rate cut, we definitely are looking for a dovish statement because inflation should edge lower from the current reading. If there is no rate cut, the bonds will likely sell off, but you should see a bigger sell-off in the swap market. But overall, the story would remain that you would see higher than expected of open market operations (OMO) for this year, a little bit of increase in FII debt limit as well which happened a couple of years back. So, the entire being bullish on bonds story remains for the rest of the year. But you could see a little bit of a sell-off if there is no rate cut.

Latha: So, by December 31, what? Is it 6.6, a good chance of a 6.5?

Bhargava: I would tend to think that there is a good change because monetary policy should continue to remain accommodative.

Latha: Do you think dollar is going to be a problem? We just had W Willem Buiter of Citi saying that Indian equity markets are in the risk of becoming a safe haven market. There have been pressures from the government as we know, wanting the Reserve Bank to weaken the rupee. Do you think that is going to be possible or the rupee is going to be stubbornly appreciating?

Bhargava: I would tend to think that there is a bit of an appreciation bias in terms of what we have seen and what we have interacted with, in terms of the buying activity on the trading side. So, first of all, this entire argument about can you really help exports by depreciating INR? It is overdone. We have gone through it over and over again.

Global demand is expected to pick up as per our estimates next year and which should impact Indian exports positively. But, beyond that, there are a lot of other factors which have to work, rather than the currency. So, we are not expecting any currency depreciation pressures in particular. In fact, we are looking at a dollar bearish environment for the next 3-6 months. So, that should give a little bit of an upside to the rupee.

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