Why no one is worried about the MPC's rate hike

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 Why no one is worried about the MPC's rate hike

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• MPC, de-glamourised! The MPC (Monetary Policy Committee) of the RBI outcomes were drivers of market-sentiment (till recently). Future direction of interest rates were known through that. But in June 2018, we saw traders and investors taking the 25 bps repo rate hike in their stride, and the markets (stock and bonds) did not react in a big way.
• What the rate hike means? An end to 'cheap money policy' of past 3 years. Stocks went up. In the bonds market, there was only a 9 bps rise in 10-year G-sec. The dovish hike was welcomed!
• Bond markets : The MPC did not change anything in past 10 months, but the bonds markets have seen yields of 10-year govt. bond (benchmark for market interest rate) go up by 123 bps to 7.83% from 6.60% (it even crossed 8% briefly). The markets had already done what they would do post-MPC repo rate hike!
• Dynamics of bond markets : (a) Demand-supply mismatch in G-secs : The PSBs, to maintain their 19.5% SLR, would scoop up whatever paper would be offered. But DeMo (demonetisation) gave them so much liquidity that their SLR went up to 30%. (b) Credit offtake in recent months : Banks slowed G-sec purchases to lend more, so biggest buyers were out. So prices went down, yields went up. (this leads to capital losses for bondholders).
• Global conditions : Since interest rates are firming up, FPIs are running away. April 1 to June 6 2018 - more than $6.7 billion withdrawn. Yields went up (fewer buyers). So long-datedG-secs found little interest from insurance firms, MFs and pension funds.
• Inflation rate : Market players have kept an eye on inflation projections by the RBI. Rising crude oil prices, and consequent RBI projections, helped them factor that into calculations already. 
• The logic : G-secs are sovereign bonds. Their interest rates are the "floor" for all other borrowers. Hence the 123 bps hike in past 10 months has led to higher interest rates (for borrowings) for corporate bonds and CP also. They find money expensive now. That is known to stock markets - hence unfazed in June!
• Banks acted earlier : Similarly, due to low deposit growth rate (why? - 1. Post demo., 2. FRDI bill fears) and higher credit offtake, banks have raised deposit rates already (25-50 bps) to attract funds. RBI rules mean that banks have had to peg their lending rates to higher deposit rates (incremental cost of funds rule). So for SBI, the MCLR is now 8.25%, up from 7.95%.(MCLR = Marginal Cost of Funds Based Lending Rate)
• Bad news for RBI : If the markets start pre-empting everything, then the power of MPC to (a) control inflation, (b) push growth or (c) manage exchange rates also reduces. Sounds like the Impossible Trinity!  
• What can MPC do? (a) Better forecasting of inflation and prices, than the market, (b) New Inflation-Targeting framework of RBI (and Centre) in 2015 means RBI has been legislatively bound to chase a CPI inflation target of 4-6%. Other dynamic market factors are out - GDP numbers, deficit indicators, foreign flows etc. By reverting back to that, the RBI can have greater impact through the MPC.
• Restore that flexibility : If the govt. restores the RBI's flexibility to respond to market forces (demand from banks, foreign flows, GDP numbers), it will still remain relevant in the game.
• Summary - Through its monetary policy, the RBI has to manage inflation, growth and stability of exchange rate objectives simultaneously. Markets have now started pre-empting the RBI MPC rate movements. Time for some change.

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