The Reserve Bank kept its policy interest rate unchanged and maintained its policy stance as ‘accommodative’ in the monetary policy committee (MPC) meeting held last week. The central bank has turned more cautious regarding the economy’s prospect than it had been in February 2022 due to the subsequent geopolitical developments and consequent spike in commodity prices. It sees more upside risk to inflation and more downside risk to growth due to the recent development in geopolitics, commodity prices, and supply side disruptions. As a result, its estimate for inflation in 2022-23 was moved up to 5.7 percent and the estimate for GDP growth in 2022-23 was moved down to 7.2 percent.
In the previous MPC meeting, held in February 2022, RBI was focused more on growth and, when brought to notice, the risk of inflation was downplayed as trivial and transient. That perspective seems to have changed now, as RBI in its latest meeting announcement, affirms that inflation has emerged as a risk, and elucidates that it is focused on withdrawal of accommodation so that inflation remains within the target range.
The monetary policy has, basically, three phases or stages which usually happens in a cyclical manner. The phases are easy, normal, and tight. When the economy is in a recession or economic slowdown, the central bank will adopt an easy monetary policy which involves reducing interest rates and injecting liquidity into the markets. The purpose is to provide support to the economy and to revive growth. These actions that are part of easy monetary policy will have consequences, mainly high inflation and asset bubbles, so that the central bank reverts to normal monetary policy once sustainable growth and stability in economy becomes visible. Similarly, when the demand in the economy far exceeds than that can be produced by the economy, the central bank will adopt a tighter monetary policy to prevent the economy from overheating. The tighter monetary policy steps involve raising of interest rates and tightening of liquidity conditions.
Monetary policy and Stock prices
The stock prices have correlation with the monetary policy, and it is essential for an investor to be aware of it to make better investment decisions. We need to have a proper understanding of the direction and stage of the current monetary policy and how stock prices performed historically in those phases. Historically, easy monetary policy periods have been favorable for stock prices, and they have outperformed during these periods, while tightening monetary policy phase are unfavorable and stock prices under-performs.
The RBI has reduced policy interest rate – the repo rate – from 6.50 percent to 4.00 percent over the last 3 – 4 years, and as part of pandemic response, it has injected excess liquidity into the system. We can augur from this that we were in an easy monetary policy phase for the last 3 – 4 years. But that seems to be changing is what we can infer from the latest MPC announcements. The policy interest rate was kept unchanged at 4.00 percent for more than a year, economic activity is reviving, and most importantly high inflation has emerged and is acknowledged as a serious risk, and all these are evidence that we might be at a point of pivot in monetary policy from easy to normal, and from there to tightening. This trend is visible around the world, as major global central banks withdraw their pandemic induced liquidity measures and raises interest rates because of high inflation and visibility of economic growth and stability.
Market Outlook
You shouldn’t expect, for the next 2 – 3 years, the kind of returns provided by markets in 2020 and 2021 as those returns was largely fueled by the massive liquidity injections into financial markets done by central banks to protect households and businesses from the devastating consequences of pandemic-induced lock-downs. That tailwind doesn’t exist anymore as central banks and governments have started moving towards a more normal monetary policy phase and may even move to a tighter monetary policy phase due to the persistent high inflation.
I believe that fundamentals will be the major deciding factor of how stock prices will perform over the medium-term. The companies with strong balance sheet, good business economics, high growth in sales, profit, and net-worth, and whose stock prices are available at reasonable valuations will provide superior returns, unlike 2020 and 2021, which was a ‘rising tide lifts all boats’ kind of market.
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