Comments on Annual Monetary Policy for 2011-12 - AXIS Mutual Fund

The Reserve Bank of India announced its annual monetary policy for the financial year 2011-12 today with a hike in Repo and Reverse Repo rates by 50 basis points each. The interest rate on Savings Bank accounts has been increased by 50 bps to 4%. The other key policy rates including the Bank Rate and the Cash Reserve Ratio were left unchanged.

The RBI has been following a policy of calibrated rate hikes in an effort to rein in inflationary expectations without slowing growth. However, in view of the sticky nature of inflation and its recent acceleration, the RBI has tilted its monetary stance towards fighting inflation even at the cost of short term growth. The RBI projects inflation to remain elevated during the first half (projected at 9% by September 2011), and declining to 6% by March 2012. Growth forecast has been scaled back and the RBI expects growth at 8% for the current financial year.

The RBI also changed the mode of operation of monetary policy. The rate corridor approach has been abandoned in favour of a single policy rate, viz. the repo rate (7.25%). The target for monetary policy would be to maintain the inter-bank call rate close to the policy rate. A new Marginal Standing Facility at a fixed spread of +100 bps and the Reverse Repo at a fixed spread of -100 bps to the policy rate will be available to handle situations of very tight and very easy liquidity conditions.

Money supply growth is projected to grow at 16% this year, funded by deposit growth of 17%. Bank credit is expected to grow at 19% (compared to a 21.4% growth last year).

With the various monetary measures announced, the Bank expects to (i) contain inflation by reining in demand side pressures and (ii) sustain growth in the medium term by containing inflation. A key change in the policy stance is that the RBI is willing to sacrifice short term growth for more sustainable medium term, low inflation growth.

Yields in the money and bond markets rose in response to the RBI policy actions. Yields in the 1-month segment rose by 25 basis points, while the 10-year gilt yield rose by 6 bps to 8.20%. We expect short-term rates to continue to rise on the back of policy actions with a flattening of the yield curve, i.e. longer-term yields would rise slower than shorter-tenor yields. In a rising rate environment, we expect to maintain short duration stance in our fixed income portfolios.

Review of monetary policy during 2010-11

During the course of the last financial year, the RBI has taken several monetary steps in line with these overall objectives, including increases in the repo and reverse repo rates by 175 and 225 basis points respectively. Despite these steps, inflation has remained on an accelerating trend.

RBI's actions over FY2010-11 could be classified into two: contractionary (anti-inflation) and expansionary. The contractionary steps include the rate hikes and maintenance of tight liquidity conditions, however the expansionary measures too have had an impact on growth and inflation.

The key expansionary steps taken by the RBI have been reduction in SLR by 2 percentage points and the injection of liquidity through the Liquidity Adjustment Facility and through Open Market Operations (Quantitative Easing). The total addition of liquidity amounted to over Rs.1.7 lakh cr. (over 3.5% of GDP). In comparison the current Quantitative Easing programme (QE2) of the US Federal Reserve amounts to about 4% of GDP. The RBI expanded its holding of government bonds by 76% over the course of the year.

The QE steps of RBI contributed to keeping growth on track, allowing bank credit to expand rapidly even in a tight liquidity, rising rates environment. It also limited the rise in gilt yields over the year. However, while the Fed's QE2 comes at a time of slowing growth and very low inflation, RBI's QE comes at a time of high and accelerating inflation. The quantum of expansion of reserve money through OMO in the current year remains to be seen.

Source : Equity Bulls

Keywords