RBI left its key policy rate unchanged at 6.25 per cent. The decision was largely unexpected by markets but not by BNP Paribas. We were in a small minority expecting unchanged policy rates.
Three factors appear to have been key to the unchanged verdict. First, RBI is clearly cognisant of increased global uncertainty. “Imminent tightening” by the US Fed, the risk of “large spill-overs” to emerging markets and “firmer oil prices” were all cited as reasons for policy caution. Second, the stickiness of inflation, particularly “core” inflation, was noted as “disconcerting” and potentially generating a resistance level for future downward movements in inflation. RBI acknowledged inflation risks are skewed to the upside even before the full impact of the 7th Pay Commission on housing costs, let alone the likely inflationary impact of GST, have been factored in. Third, RBI sensibly decided to view demonetisation and the ensuing disruption to the economy as a largely “transient” shock that, in the base case, does not warrant a formal policy response.
While GDP growth will clearly take a hit in the current quarter, growth can be reasonably expected to rebound smartly in the New Year. If the impact of demonetisation proves to be longer lasting and more pernicious, RBI rightly left its options open to respond with easier policy at a later date.
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Demonetisation has also inevitably generated severe liquidity management issues for RBI, given the surge in bank deposits. In a separate press release, RBI confirmed the temporary expedient of the incremental reserve requirement increase that locked up over Rs 3 lakh crore of deposits and which helped re-anchor money market rates back towards the repo rate will expire on December 10.
Management of excess liquidity will then revert back to the more orthodox use of reverse repos and issuance of market stabilisation scheme (MSS) securities until excess liquidity pressure fades, hopefully in the next few weeks. Deputy Governor R Gandhi noted during Wednesday’s press conference that around Rs 12 lakh crore of the Rs 14.5 lakh crore of bank notes have now been returned, signalling their expectation that liquidity shock is now close to abating.