RBI’s stance on interest rates: Will it, wont it?

• HDFC securities
• 05 Jun 2018
• Knowledge Centre

In our opinion, though the possibility of the Reserve Bank of India (RBI) maintaining a status quo in interest rates in its second bi-monthly monetary policy review for 2018-19 is high, there is also a great likelihood of a change in its stance from ‘accommodative’ to ‘hawkish or withdrawal of accommodation’.

 

The spurt in crude oil prices and core inflation would be the main reasons for this shift. There has been a 10% increase in the price of crude oil following the last monetary policy meeting on 5th April 2018. Though RBI is not actively involved in the currency markets, it does intervene at times that call for an easing of volatility. This is reflected in the current situation, as effective management of the currency is critical for inflation management.

 

Inflation Factor

 

A rapid rise in crude oil prices to a four-year high in just two months, accompanied by a notable depreciation of the Indian Rupee have worsened the inflation outlook. The Organization of the Petroleum Exporting Countries (OPEC) and Russia have indicated that though crude production could be increased, prices are unlikely to come down significantly.

 

The central bank is expected to tackle the situation with a no-holds-barred approach to elude another plunge in the value of the Rupee, taking other asset classes with it. The signs of this are already visible, as FY19 has witnessed foreign portfolio investors selling shares and bonds worth US$ 6.6bn.

 

Some Breathers

 

One factor that is expected to lessen the severity of RBI’s stance is that the gross domestic product (GDP) figure released last week reflects a 7.7% growth in the economy in the fourth quarter of FY18.In addition to this, we are of the view that though the possibility of a hike in the interest rate in this policy meetingis not high, chances of it taking place in the August 2018 and October 2018 monetary policy reviews are.
The central bank is expected to hold interest rates until the onset of the monsoon. Though expectations of a normal monsoon are high, there is a risk of a notable hike in the minimum support price (MSP), as announced in the Union Budget. This could trigger a rise in inflation.

 

The resolution of the Monetary Policy Committee (MPC) will be announced on 6th June 2018. Currently, the repo rate stands at 6%, and the reverse repo at 5.75%.

 

Overseas Pressure

 

Recent signs of stress in Italy and emerging markets like Argentina, Brazil, Turkey,and South Africa also call for RBI to be aggressive while dealing with this situation to avoid a free fall in the value of the Rupee. Theoretically, this requires a combination of tight liquidity that pushes bond and money market rates up, and an increase in the policy rate to ensure that the central bank is in step with the curve. However, RBI will again face the same dilemma of raising rates at a time when economic growth is just starting to gain momentum (going by the GDP number for Q4FY18 released recently). This has to be measured against:

 

• A slowdown in private consumption in FY18, 
• Early evidence of a slowdown in emerging markets’ export growth, 
• Japan's economy contraction, 
• Muted wage growth in India.

 

All of these suggest a cooling off of growth rates globally as well as in India.

 

While moving straight from an accommodative stance to hiking rates is one possibility, we believe MPC members may want to adopt a gradual approach in the June meeting. A decision to raise rates in the August meeting will be more appropriate, as by then we will have a fair idea about the monsoon and MSP rates, and their impact on inflation. Real rates were high at 150 bps currently also supports this view.

 

We are cognizant of the fact that the gap between repo rate (6%) and the 1-year bond rates has risen to 90bpsv/s the 10-yr average of 25bps. In the last 10 years, this is only the fourth time that the yield–policy rate gap has been so high. On three previous occasions, policy rate hikes have followed. The difference is only the timing of rate hikes, which we feel could be in August.