The Federal Reserve raising its rate hike guidance by a full 50 basis points has moved many in the market into expecting that India's Monetary Policy Committee (MPC )will prefer a 50 bps hike over 35bps or 25 bps.
On the face of it, the MPC with its inflation targeting mandate will cringe from accepting this "external" factor. Yet it may be inevitable this time around. The RBI has always averred that it sets rates purely based on domestic factors and is not influenced by external factors. I would argue that the Fed’s new dot plot is also an input into India’s inflation targeting MPC.
Firstly what did the Fed do? It’s dot plot (which shows how the members think about future rates) in June showed that a majority of the members see rates at 3.75 percent by December and peak at 4 percent next March. The September 21 dot plot shows that a majority see rates at 4.25 percent in December and peaking at 4.50-4.75 percent by March 2023. This sharp hike in guidance led to surging of US yields and strengthening of the dollar which, in turn, caused hot funds to quit EMs and rush towards dollar bonds. The rupee saw one of its biggest single day falls on Thursday as it dropped from 79.97 to 80.86 a dollar.
When the risk-free instruments (like 2-year US Treasurys) give investors over 4 percent, they need a bigger incentive to stay in rupees, as here they can face depreciation losses and hence central banks like RBI have to hike rates somewhat in step with the Fed.
But there is an inflation connect here. There is much noise in India that the US CPI hit 9 percent versus their target of 2 percent, while India’s CPI at 7 percent is higher than the target of 4 percent but the deviation from target is much less than in US and hence India needn’t hike rates as much. This argument misses an important inflation connect. The Fed targets not CPI but the inflation indicated by the PCE or the personal consumption expenditure.
The PCE stood at 6.8 percent in June and fell to 6.3 percent in July. The Fed sees the PCE falling to 2.3 percent by 2024. In contrast the RBI sees India’s CPI fall to 4 percent by 2024 from 7 percent today. Clearly inflation in India is stickier than in the US. By 2024, India’s CPI will be 2 percentage points higher than the US and hence if the peak rate in the US is 4.5 percent, India’s needs to be 2 percentage points higher, in the least.
In, short raising rates because of the Fed’s hawkish stance also has a crucial connection to the MPC’s inflation mandate and interest rate policy here.
Coming to India’s domestic inflation - the primary concern of the MPC – has inflation become a tad entrenched is a very good debate to have. Firstly,. Cereals inflation has picked as of August.
And, there is a fear that vegetable price inflation may follow suit. India’s food inflation is worrisome and may persist if vegetable prices rise due to wayward rains. Food inflation can get generalised into demand for higher wages very quickly.
Secondly, growth is strong albeit more in urban than in rural areas and more in the upper echelons than at the base of the pyramid. The demand for SUVs, the rise in the PMI index, surge in bank credit led largely by retail loans and the runaway rise in imports all indicate that the MPC needs to ensure positive real rates very quickly.
If inflation remains around 5 percent for a better part of FY24 as the RBI forecasts, there is a need to get to 6 percent repo rate earlier rather than later. A rate hike of 50 bps can bring the repo to 5.90 percent. May be even a 60 bps hike to take the repo rate to 6 percent is not a bad idea.
A word more on imports. There is much celebration that merchandise exports will cross $400 billion yet again this year. What we need to notice is that April-August exports have grown 17 percent, while April-August imports have grown 45 percent. And this huge import bill isn’t entirely or even largely because of oil price.
Non-oil imports from April to August has grown by 32 percent, while non-oil exports have grown only 8 percent. The point is the strong growth in urban wages is directly leading to demand for higher imports which inturn is fuelling a sharp rise in the current account deficit. There is a need to cool down growth, even if it is anemic in certain parts of the country.
The sharp fall in crude prices and the feared recession in developed markets have been put forth as reasons for soft pedalling on rate hikes, but India's inflation is no longer caused by crude alone. It's more broad-based with core and food contributing amply.
The case for a 50, even 60 bps hike starts with domestic reasons. The Fed has only sealed the case.
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