Vikas Garg of Invesco Mutual Fund expects repo rate at 6% by December, says inflation to stay elevated

Repo rate hike of 50 bps (basis points) to 5.40 percent by MPC came in line with our expectations and towards the higher end of 35-50 bps of market expectations. Elevated inflation trajectory, which continues to remain above RBI's medium-term target, and the aggressive tightening by major central banks has prompted the MPC to raise policy interest rates towards the higher end of market expectations.

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Recent market expectation built up was that MPC would indicate a pause or a data-dependent approach for future rate hikes as (prices of) global commodities, including food items, have come off sharply since the last MPC (meeting). Also, global rates (please check this word. May be you mean equities) rallied over the last month with expectations of less aggressive global rate hikes amidst recession fears. MPC, on the contrary, continued with its last policy narrative and sounded hawkish on global uncertainties, inflation trajectory and kind of special focus on external factors, thereby signalling more front-loaded rate hikes to continue in upcoming policies.

With the 50-bps hike, repo rate is now at pre-Covid levels. Do you expect another 50-75 bps repo rate hike by end of FY23 or by December 2022?

MPC has clearly articulated its concern on inflation which is reflected in retention of inflation forecasts for FY23. We believe supply-side disruptions, geopolitical tensions, commodity prices and improving domestic demand conditions pose risks to the inflation outlook while the growth seems to be fairly supported by domestic factors. Anchoring the inflation trajectory remains a key priority for the MPC and given the current inflation trajectory, we expect it to continue with front-loaded rate hikes.

Additionally, with the narrative in August MPC on external global factors, we now expect the policy repo rate to reach ~6 percent by December 2022 / February 2023, faster than our earlier expectations of April 2023. Further rate hikes, if any, will depend on the expected inflation trajectory in FY24 which is still evolving and dependent on geo-political uncertainty.

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Do you think the inflation can fall below the 6 percent threshold by the end of December 2022?

On the assumption of a normal monsoon in 2022 and average crude oil price (Indian basket) of $105 per barrel, RBI has retained CPI (consumer price index) projection 6.7 percent in FY23 while it has revised it upwards for Q3FY23 from 6.2 percent to 6.4 percent with the risks broadly balanced. RBI has sounded cautious on inflation projection despite the recent correction in commodity prices and cumulative rate hikes of 140 bps indicating the uncertainties.

We believe that inflation trajectory is uncertain on geo-political risks and quantum of rate hike by the US Fed and as such is expected to remain elevated, especially over next few months, on energy prices. On domestic front, notwithstanding the recent correction in metal commodities and a benign monsoon outlook, the next few months remain very critical for the inflation trajectory. While the domestic inflationary factors have softened to some extent, global uncertainties still persist and can put upside pressure on local inflation prints. Additionally, once the domestic economy comes back to normal, risk of demand-side factors may also play out on inflation.

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Is the RBI's growth forecast at 7.2 percent for FY23 looking achievable? What are the likely risk factors for this growth forecast?

RBI sounded confident on the growth recovery across the segments and retained the real GDP projection at 7.20 percent for FY23. This stems from that fact that capacity utilization in manufacturing sector is above the long-run average and needs additional capacity creation.

Further, an uptick in bank credit growth, improving urban demand and likely pick-up in rural demand on the back of improvement in agricultural prospects, should help the economic growth. Downside risks to growth can emanate from a) an upsurge in Covid-19 leading to state lockdowns b) elevated inflation forcing MPC to tighten monetary policy far more quickly and c) global growth slowdown amidst recession fears in few major economies.

Currently the 10-year treasury yield is at 7.3 percent. Do you expect the yield to cross 8 percent by the end of this calendar year?

Record high fiscal supply in FY23 remains a challenge in the absence of RBI’s Open Market Purchase Operations and any meaningful FPI (foreign portfolio investment) inflow in the debt segment. The central government's recent fiscal expansionary measures to partly absorb the high prices in a few global commodities have been largely compensated by higher taxes on energy products, thereby reducing the overhang to an extent.

Notwithstanding (that), any further flare-up in inflationary pressure may prompt the central government to take more such fiscal measures, thereby putting additional pressure on the overall G-Sec borrowing programme.

With challenging global backdrop, as many central banks tighten the monetary policies to tame inflationary pressures, huge fiscal supply and RBI’s expected fast withdrawal of an ultra-accommodative policy, we expect domestic interest rates to remain volatile with an upward bias.

While the short end (up to 3 years) has already factored in far more aggressive rate hikes by RBI, the longer end seems to have not yet fully factored in the uncertainties related to the global backdrop and heavy fiscal supply overhang as spread of 10-year over 3-year G-Sec remains lower than its 5-year average as of now. Taking a repo rate of 6 percent by end December 2022, we expect 10-year G-Sec to trade in the range of 7.40 percent - 7.65 percent by the end of December 2022.

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