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RBI Monetary Policy Review

30th July 2013

The RBI has been distinctly more dovish in its monetary policy statement with the central bank highlighting downside risks to growth and softening trajectory of inflation. The RBI has guided that the recent liquidity tightening measures may be rolled back in a calibrated manner once stability is restored to the currency markets. The guidance stresses on external sector stability as key variable guiding further monetary policy actions. With a largely open capital account and requirement of maintaining currency stability, inspite of having no explicit fixed targets, the RBI has admitted that the  ‘Impossible Trinity’ trilemma has constrained monetary policy responses. While a largely dovish monetary statement has provided respite to the markets in the near term, the trajectory of the INR and global central bank policies may continue to influence market movements going forward.

Given the growth slowdown and moderation in inflation, monetary policy should have been a lot benign, however, making currency stability an explicit policy objective could lead to a sub-optimal outcome on all fronts. It is always difficult for any central bank to ‘manage’ the currency while having an independent monetary policy and an open capital account. 

The foreign investors have been net buyers of bonds for last 4 sessions given the sharp uptick in short term yields. The Federal reserve policy outcome this week would be a critical event to watch out for. The Fed has stated its intention of tapering off the Quantitative easing (QE) depending on the trajectory of jobs and inflation data and markets would be nervous if there is any indication of an early unwinding of QE. 

We have been running relatively moderate duration in bond funds given the current uncertain environment and have been maintaining higher cash levels on a tactical basis. Though the longer term view remains positive given the sharp slowdown in growth and inflation. Ultimately, growth-inflation dynamics are the main drivers for interest rates, but the currency move has added a completely different dimension making us cautious.