RBI Policy – hike or no hike, the trajectory of interest rates is upward

Madhuchanda DeyMoneycontrol Research

The Reserve Bank of India (RBI’s) third bi-monthly policy meeting in the fiscal coincides with the meeting of the US Federal Reserve. Global markets expect the Fed to leave rates unchanged but guide to two more rate hikes in the course of 2018, as the US growth shows no signs of weakening and nascent signs of strength emerge on the inflation front. Will RBI adopt a similar wait-and-watch with a hawkish tone or will it front load the rate action with a 25 basis points hike on August 1?

In RBI's last policy meeting, the monetary policy committee (MPC) members unanimously flagged inflation concerns and raised rates while sounding bullish on growth. Since then, inflation dynamics have not overtly improved but development on the macro front point to a conflicting outlook on future inflation.

If the movement in the yield on the 10-year benchmark government security (G Sec) is any indicator to go by, it suggests a status quo on the rate for the time being.

Source: Reuters

There are, however, enough incremental pressure points that have built up since the last policy of June.

Inflation – a negative surprise from the last policy

In the previous policy deliberation on June 18, RBI had raised its inflation forecast to 4.8-4.9 percent in the first half of FY19 and 4.7 percent in the second half.
The emerging data points have surprised negatively with reported Consumer Price Index (CPI) rising to 5 percent in June 18 from 4.87 percent in May 18, thereby overshooting the RBI’s stated range. What is worth noting is the movement in core inflation (a measure which excludes transitory or temporary price volatility as in the case of food items, energy products) that has been inching higher month after month to touch a high of 6.5 percent in June. Incidentally, it was the uncomfortably high level of core inflation that was one of the key drivers of RBI’s rate action in the last meeting.

Source: MOSPI, Moneycontrol Research

Several other pressure points

Pre-election year largesse that could have an adverse impact on inflation as well as on fiscal deficit is a valid concern as well. As indicated in the Union Budget, the government has recently announced a hike in the minimum support prices (MSP) for a wide variety of crops. The government adopted the approach of pricing crops at least 150 percent above the cost of production. Consequently, MSPs have been hiked anywhere between 3.7- 52.5 percent and could impact CPI inflation meaningfully to the tune of 50 to 60 basis points if implemented properly.

While GST collection has improved a tad, pressure points on the exchequer are galore – the populist GST rate cut, probable launch of the national health insurance scheme, shortfall in disinvestment targets, capitalisation of PSU banks and the list goes on.

The other area of concern has been the currency which has shown weakness alongside its emerging market peers in recent times. Although the free fall appears to have been arrested, the Indian currency has lost close to 2.6 percent since the last policy.

On the other hand, the progress of monsoon has been satisfactory that might have a sobering impact on inflation. The recent GST rate cut on consumer-facing goods should also support. Finally, the supportive base effect (from July 18 onwards) could moderate inflation, going forward.

The global factor – joker in the pack

However, the big change from the last policy is in the global arena. The heightened noise on a trade war has cast its shadow on growth outlook of major economies including China and the same has had an impact on the commodity prices that have seen some correction in recent times.

While the oil market has not gone into a bearish zone, crude oil prices have softened following the output increase after the OPEC’s last meeting.

Source: Reuters

Amid the noise of trade war and the US President Trump’s displeasure over rate hikes, US Fed might leave rates unchanged in its August 1 meeting. Thus RBI too might like to wait and watch with a similar hawkish stance as the US Fed.

Has growth made a decisive comeback?

Finally, while RBI has sounded bullish and confident on the growth outlook, the ground reality continues to give mixed signals. Quarterly earnings season so far has had a decent start but one can’t read too much into the same as the base had an impact of GST implementation.

Source: MOSPI

The much-tracked Index of Industrial Production (IIP) data in recent time shows a lack of momentum, but the base could be blamed for the same again, IIP being volatile and the data being for a month, one cannot comment on it too seriously.

In the meantime, credit growth continues to be in double-digit outpacing the growth rate in deposits and bankers indicate it is becoming increasingly difficult to garner deposits without offering a better rate. So the direction of rates is clearly up, whether the rate action is tomorrow or two months later is a close call.