RBI policy: Rate hike certain; liquidity, currency, health of financial institutions key concerns

With interest rate hike being a forgone conclusion, the Reserve Bank of India (RBI) will have a larger task at hand than just the monetary policy announcement on October 5.

The six-member monetary policy committee (MPC) is set to announce the fourth bi-monthly policy statement for  FY19 amid concerns of rising inflation, widening current account deficit, weakening rupee and liquidity crisis gripping the financial markets.

Among the fears, the rupee hit a record low of  73.81 against the US dollar and in the bond markets, the yield on the benchmark 10-year bond jumped to 8.2 percent — the highest in three weeks. All this, a day before the policy announcement.

Headed by RBI Governor Urjit Patel, the MPC is expected to hike key policy repo rate by 25 basis points (bps, 0.25 percentage point) after a three-day meeting.

“A rate hike is almost certain. It is likely to be a quarter percentage (increase in repo rate) but the probability of a 50 bps increase is not ruled out,” said Saugata Bhattacharya, Chief Economist at Axis Bank.

Retail inflation had declined for the first time in 2018 at 3.69 percent in August compared to 4.17 percent in July.

However, core inflation is rising because of increasing fuel prices and now with the MSP (minimum support price hike in the rabi crops and the rising crude oil prices, it will add to core inflation.

After the government cut excise duty on petrol and diesel prices, India Ratings' estimates, suggested that the tax cut will translate in a 3.79 percent decline in the retail prices of petrol and a 3.88 percent decline in the retail price of diesel, based on prices and taxes prevailing in Delhi.

However, "...there are signs of rising demand and pricing power will also get affected in H2 of FY19 (October to March). So my sense is 25 bps with a hawkish language," Bhattacharya added.

To be sure, the objective of monetary policy framework is to primarily maintain price stability, while keeping in mind the objective of growth.

The MPC is guided by a legislative mandate to maintain the consumer price index retail inflation rate at an average rate of four percent with a band of +/- 2 percent.

However, having factored in a repo rate hike already, the market would be looking for outlook going forward and its guidance on the central bank's actions on stemming the Indian rupee's free fall over the last few weeks and the liquidity crisis plaguing the non-banking financial companies (NBFCs).

They are witnessing higher refinancing rates that could lead to compression in its margins.

Lakshmi Iyer, CIO (Debt) & Head of Products, Kotak Mahindra Asset Management, said: "The MPC meeting is happening at time when a tale of two Cs is unfolding – crude oil prices and currency. The INR (Indian Rupee) has depreciated almost 7 percent since last policy while crude oil prices are up by over 17 percent. This clearly is a double whammy for and net oil importer nation like India."

The rupee is down close to 13 percent for the year.

Further, IL&FS default and its impact on the financial market along with liquidity management will have an important bearing on the MPC resolution this week.