RBI will continue to remove the monetary tightening measures, says Morgan Stanley

Morgan Stanley expects the RBI to cut MSF rate further by 25 bps to 8.75% but to lift repo rate by 25 bps to 7.75% on the 29th October RBI meeting to review monetary policy

While initiating the tightening measures since July 2013, RBI (Reserve Bank of India) has always indicated that those measures are “temporary” in nature. The key driver to those tightening measures has been external funding risks and currency stability. RBI has been indicating that it will continue to remove the monetary tightening measures as allowed by external funding risks. This is the forecast of Morgan Stanley in its research note on the 29^th October RBI meeting to review monetary policy.

Potentially, there are three key policy measures that the RBI could adopt: (a) Cut the marginal standing facility rate (MSF) rate (upper band of policy rate) again, (b) hike the repo rate and/or (c) extend banks’ ability to access a higher magnitude of liquidity at the repo rate – transitioning to make the repo rate the effective policy rate, argues Morgan Stanley.

Morgan Stanley believes that the macro environment warrants the RBI to hold short-term rates at the current levels (if not higher). However, the RBI has pre-guided that the tightening measures initiated in July were largely in response to external funding risks. Hence the recent stability in currency markets – as the probability of US Fed tapering its quantitative easing in the near term has reduced – indicates that RBI will likely remove the earlier monetary tightening measures. Morgan Stanley expects the RBI to cut MSF rate further by 25 bps to 8.75% but to lift repo rate by 25 bps to 7.75%. The overall trend in policy rates is given in the chart below:

Morgan Stanley also forecasts a not so high GDP growth rate with low interest rates, as CPI (consumer price index) inflation remains very high. Considering that India’s savings have been declining faster than investment, the focus of policy makers should be on the real rate for savers. While, traditionally, in practice, WPI (wholesale price index) inflationhas been the key metric, followed by policy makers, over the past four years the rising gap between price levels implied by WPI and CPI meant that WPI inflation (akin to PPI elsewhere in the world) is not the effective measure of the underlying inflation pressuresthat savers are facing. A significant part of WPI represents intermediate/ input prices and not final consumption product prices. RBI’s own survey of inflation expectations has also been indicating that inflation expectations are tracking above double-digit levels.

The research note adds, in the context of the government's inability to quickly augment public savings by meaningful pro-cyclical fiscal tightening, lifting of real rates is the only credible way to demonstrate the commitment to reduce saving investment gap (current account deficit). The following chart shows that the borrowing cost is higher than the GDP growth:

 
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