At the Policy cross-roads....

The equity and bond markets both seem to be at the cross roads awaiting tomorrow's credit policy review of RBI.

While the previous one (December's) was an easy no-change consensus policy, this one is somewhat tricky.

For starters, the inflation has started threatening... particularly in all the EM countries. Most EM central bankers have become hawkish and RBI cannot afford to be giving different signals. There is already some feeling that RBI is behind the curve and they may like to put this argument at rest.

A strong hike (say 50-100 bps) will not therefore be out of sync. But, the markets are already tight with systemic liquidity taking a big hit in the last few months. The slowness of Govt spending is in turn slowing down the money supply growth and for an economy growing at 20% in monetary terms (take a realistic inflation level and add real growth level) an M3 growth of 15% is not sufficient. Alternatively put, a level of Rs 1 trillion borrowing by the system from RBI everyday is a situation requiring liquidity injection. 

The latest IIP numbers are none-too-great and while it is a volatile number, it does put a question mark on presumed continuance of the growth story. Same is the case on other asset prices.

Then there is this age-old argument that most of the inflation is in primary articles' i.e., food and petroleum prices and how much of impact do monetary measures have on such inflation? The issue is not a settled one. However, there may be merit in the argument that eventually all inflation is monetary!

   

For the liquidity injection, it may be presumed that RBI will detest aggressive measures such as CRR reduction and/or further OMO. They may like to wait out for Govt to return to its spending ways and also extend the 1% additional eligibility for LAF.

For the Repo corridor then, the expectation would be a 25 bps hike + tough talk. After all the frequency of meetings is higher and they could always hike outside the meetings, in case of a data surprise.

Alternatively a repo hike of 50 bps can be contemplated as more and more participants seem to be grudgingly accepting the need for tougher monetary stance (and what is discounted doesn't hurt!) and the need to get in line if not ahead of the curve.

 

My choice would be to hike all the way, say by 100 bps, but simultaneously withdraw the additional 1% LAF in favour of a 1% CRR cut. While this may be logical for markets, it would not perhaps be politically correct. Hence I think I will settle for a 50 bps hike as the more likely option.