Surging Crude, Weakening Rupee Set Stage For Rate Hike In October 2018
In a flexible inflation targeting regime, the Central Bank is likely to focus on the key risks to the inflation outlook, while taking monetary policy decisions. In the current Indian context, such risks include both the elevated crude oil prices and the depreciation of the rupee, which are expected to enlarge domestic price pressures going forward.
The year-on-year (YoY) CPI inflation declined to a 10-month low 3.7 per cent in August 2018 from 4.2 per cent in July 2018, easing below the Monetary Policy Committee’s (MPC’s) medium-term target of 4.0 per cent after a gap of 10 months. The relief associated with this has paled in light of the surge in global crude oil and domestic fuel prices, following rising concerns about the impact of the impending US sanctions on Iran.
This has contributed to an upward revision in the estimates of India’s current account deficit for FY2019, given the country’s dependence on imported fuels. The latter, in conjunction with weak global sentiment related to emerging market currencies, has resulted in a considerable depreciation of the Rupee relative to the US$.
To curtail the weakness in the currency, the Government has announced several measures, which are intended to reduce the current account deficit (CAD), and boost financial inflows, particularly debt flows, to offset the CAD. However, their impact on the currency has been limited so far.
As expected, the US Federal Reserve has increased their target range for the federal funds rate by 25 bps in September 2018. Moreover, the Fed has signaled the likelihood of one more rate hike in December 2018, followed by another three hikes in 2019, which would protect the strength of the US$, at least in the immediate term.
The intensification of inflation risks posed by higher crude oil prices and a weaker rupee suggest that headline CPI inflation is likely to range between 4.6-5.0 per cent in Q4 FY2019. Accordingly, we expect a third consecutive rate hike in the October 2018 policy review, along with a change in stance to withdrawal of accommodation, despite the softer inflation print for August 2018.
A change in the stance of monetary policy would signal the possibility of another rate hike in December 2018, unless key inflation risks such as crude oil prices and the INR record an appreciable reversal in the intervening period.
The repo rate hike in August 2018 had helped to mildly revive the foreign portfolio investors’ (FPIs’) appetite for Indian debt. However, the weakening INR and concerns related to market volatility have resulted in a resumption of FPI outflows from Indian debt in September 2018, although the size of these outflows has been smaller than the average US$1.9 billion per month recorded in March-June 2018. Whether another rate hike succeeds in encouraging portfolio inflows and thereby reducing exchange rate volatility, remains to be seen.
The RBI infused durable liquidity by purchasing Government securities of Rs. 200 billion through open market operations (OMO) in September 2018, and has since announced that three tranches of OMO purchases for an aggregate amount of Rs. 360 billion would be conducted in October 2018. In addition, the increase in the Facility to Avail Liquidity for Liquidity Coverage Ratio, from 11 per cent to 13 per cent, is expected to enhance the ability of banks to avail liquidity from the repo markets against the provision of collateral. Additional measures to address market liquidity concerns do not necessarily need to be dove-tailed with the MPC’s monetary policy decision, in our view.
