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3 things to note from RBI releases after credit policy
This was the most important event of the week. Benchmark indices fell on Tuesday when the Reserve Bank of India announced that it was keeping key rates unchanged. The decision was taken despite calls from businesses and even finance minister Arun Jaitley to cut rates. Stock markets hoped for a surprise rate cut to stimulate growth in the economy. After the credit policy announcement on Tuesday, the RBI governor Raghuram Rajan and deputy governors of RBI interacted with the press and analysts. RBI makes transcripts of these conversations public and they reveal insights into the thinking of India's central bank.
Here are pointers that explains RBI's interaction with analysts:
Inflation base effect:
An important function of the RBI is to control inflation. Retail inflation, as calculated by the consumer price inflation index, fell to around 6%, is way below the target set by RBI. Governor Raghuram Rajan admits that the fall is much sharper than anticipated by RBI. An important factor is the base effect. This means, growth in prices today is in comparison to prices prevailing in the year-ago period. The inflation appears low because it was much higher last year. This base effect is expected to wane over the next two months. Hence, RBI would like to see that the lower trajectory of inflation continues even after the base effect goes over the next 2-3 months. This is to ensure that it does not cut rates in a hurry only to raise them if inflation goes up again.
Another important factor that RBI looks at is the expectation of inflation going forward. Over the past nine quarters, consumers continue to have expectation of around 15-16% on inflation. The RBI governor says that expectations vary from market to consumers. The market expectation of inflation and effective interest rates are reflected in the yield that 10-year government bonds are traded at. This is around 8%. The consumer expectation is more linked to household items they buy. Governor Rajan explained that RBI would observe the change in expectations more closely than the actual number of these expectations. This really means RBI looks at signals from future surveys where expectations of all are that of low inflation.
Government's excess expenditure over income is a major worry. This is the fiscal deficit that needs to remain in control for RBI to commence rate cuts. The government reached 90% of the target for fiscal deficit in 2014-15 in October 2014. To achieve the miracle of not exceeding this target by a wide margin, two things have to happen. The government's expenditure needs to be cut and revenue has to grow. According to the government data available till October 2014, total government revenue receipts stood at just under 38% of the target set in July 2014 budget. While the government has announced a 10% cut in non-plan expenditure, it may not be enough. RBI governor Rajan has highlighted that a weak tax revenue growth and slow pace of disinvestment suggest some uncertainty. If the government fails to meet revenue targets, it may have to borrow from the market and that stokes inflation.
When anyone looks at cost of money in a country, the benchmark is usually 10-year government bond. These are bonds issued by the government through RBI for a 10-year period when it needs money. They are traded largely in the institutional market. Over the past one month, the yield on these bonds fell to 8.19% from 8.49% in October 2014. According to RBI, this is largely due to adequate money supply and low demand for bonds. The governor also said in his statement that the market was expecting a rate cut due to declining inflation. As an equity investor, this is an important indicator. When bond yields fall, stock markets usually trend lower.