RBI likely to raise rates at Friday's review
The Reserve Bank of India's (RBI) monetary policy committee (MPC), which is scheduled to start its three-day meeting from Wednesday (today) to decide on the fourth bi-monthly monetary policy, is likely to hike the policy rate by 25 basis points on Friday, the third time this year.
The rate review is set against a challenging backdrop both globally and domestically. The US Federal Reserve has hiked rates for the third time during the year and the eighth time since late 2015, lifting US rates and the dollar. In addition, crude prices are at a four-year high, geopolitical tensions are aggravating the situation in India's external balances and weakening the rupee. .
Domestic liquidity is also tight. The US Fed still foresees another rate hike in December 2018, three more in the next year and one more rate hike in 2020. .
According to economists, US rate hikes, domestic risks in the form of inflationary concerns on account of weakness in the Indian rupee and higher oil prices will drive RBI for a rate hike and this time the central bank may also change the stance to hawkish. .
The MPC has hiked the policy rate at two successive meetings in June and August review, citing future uncertainties, and kept the neutral stance unchanged. The repo rate currently stands at 6.50 per cent. Just before Friday's policy, several lenders such as HDFC Ltd, State Bank of India, ICICI Bank and Punjab National Bank have raised their lending rates this week anticipating a rate hike. .
The MPC's policy mandate: Inflation fell to 3.69 per cent for August helped by a high base effect which will provide support for the next 2-3 months. CPI for July was 4.17 per cent and is likely to remain benign in September and October. .
According to Madan Sabnavis, chief economist at Care Ratings, "There is still discomfort in the CPI number even as it is sub-4 per cent level which is mainly due to the food products category which has a weight of around 54 per cent in the index. The non-food components continue to exhibit higher growth rates- especially fuel and light which had gone up by 8.5 per cent. This component would tend to increase further in the coming months. Going ahead, the cushion of declining food prices may be reversed if the MSP is effective. We are looking at CPI inflation in 5-5.5 per cent range by end March." .
"Given the developments in oil market and currency we expect a rate hike of 25 bps in October policy notwithstanding the sub-4 per cent inflation number," added Sabnavis. .
Concurrently, a 10 per cent rise in global crude prices is expected to lift headline CPI by 20-30 bps according to the RBI, assuming a complete pass-through. .
"The cumulative impact might, however, be higher if we include the second-order pass-through of high transport costs feeding into manufacturing/ food costs, if high crude prices sustain. A weaker rupee by around 5 per cent could prop inflation up by around 20 bps. These reasons will provide sufficient justification to the central bank to tighten policy levers in October," said Radhika Rao, economist at DBS Group Research. .
"Secondly, a deteriorating current account balance is also symptomatic of a domestic investments and savings gap. This requires not only real deposit rates to be attractive to draw higher household savings towards financial assets, but also for the government to stay on track with its fiscal consolidation roadmap to lower its dis-savings," added Rao. .
Also the changes in Fed rates normally have an indirect impact on the economy as it affects foreign investment flows, exchange rate and monetary policy decision (depending on the impact on inflation). RBI has tracked the rising interest rate scenario in the US economy during the calendar year 2018 by having interest rate hikes (2 times) equivalent to the US Fed, prior to the US Fed meeting last month. The gap between the US interest rates and RBI rates has narrowed from 4.5 per cent in January'18 to 4.25 per cent in August 2018. .
If the RBI hikes interest rates in the scheduled meeting on October 4, 2018, the gap will widen again to 4.5 per cent. The gap has significantly declined from 6.25 per cent since the beginning of January 2016. The Fed rate hike will strengthen the dollar and a higher interest rate along with elevated crude oil prices will lead to an outflow of foreign capital, weakening the Indian rupee further in the short term. .
"A hike in the interest rate by RBI would keep the gap stable between the two interest rates, which will augur well for the foreign investors. A higher interest rate in India will in turn lead to rising yields and higher cost of borrowings for the corporates, adversely affecting the investment scenario and growth prospects of the country," said Sabnavis. .
Meanwhile, the RBI last week announced several measures to ease the tight liquidity. Following last week's Rs 10,000 crore open market operations (OMOs), the RBI announced a bunched-up bond buyback plan worth Rs 36,000 crore for October. The 10 year bond yields eased in the 8.03-8.10 per cent range last week, before slipping towards 7.9 per cent (generic) on Monday; yields closed at 7.98 per cent. The government also announced a smaller borrowing program for 2HFY19, suggesting favourable supply-demand dynamics. .
According to Karan Mehrishi, Lead Economist at Acuité Ratings and Research further liquidity management measures can be expected in the run up to the monetary policy statement. The tightness in the liquidity was clearly visible with the spurt in the weighted average call money rate (WACR) and its differential with the repo rate narrowing to only 4 bps over the last fortnight. RBI has already permitted banks to avail additional liquidity, if necessary from a larger pool of high quality liquid assets (HQLA) which is kept as SLR. .
"RBI is expected to employ various liquidity management tools to ease the tight liquidity and the volatility in the money markets triggered by the sharp depreciation in the rupee and the recent defaults in Commercial Papers (CP) by a large conglomerate," said Mehrishi. .
Columnist: . Falaknaaz Syed .