The RBI is unlikely to change its policy stance despite rising global oil prices and interest rate hikes by the US Federal Reserve. While inflation concerns grew after August, the MPC did not see the economy overheating. Experts now watch if recent price pressures across sectors show signs of generalization.
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From the previous policy, much has changed in terms of the economic atmosphere.
First, oil prices have hardened, and with a resolution to the West Asia crisis not in sight, it is becoming difficult to predict oil prices in an atmosphere where global growth is still holding up and strategic reserves of oil across the world are depleting. What was apparent in the MPC minutes was that oil was being considered at $90 a barrel in the remainder of the year. Brent crude oil is now sitting at around $103 a barrel while the India Basket is at $116 a barrel.
Second, the US Federal Reserve has started to hike policy rates, joining other large central banks that have aired inflation concerns over the elevated oil and commodity prices and have hiked rates. And it is broadly expected that inflation fears are likely to lead to tighter monetary policy. Third, global yields have hardened considerably, and even as India yields have risen, the gap between the US and India yields has closed out to an extent. And the closing interest rate gap is probably also putting pressure on flows into the domestic economy.
The minutes of the August meeting indicated nervousness about the inflation dynamics and called for cautious monitoring of the inflation trajectory for signs of emergence of second-round impact. However, no action was taken in August as MPC members did not see the economy overheating, nor did they see any generalisation of the supply-driven inflation.
Thus, the question to ask is: Does the August reading of inflation show signs of generalization? The momentum in food inflation has been strong in the past 3 months leading into August. Weak monsoons and weak soil moisture and reservoir levels have also created a situation whereby rabi sowing can run into some problems.
On the other hand, core inflation momentum also appears to have picked up. CPI excluding food and beverages and fuel and light has shown a momentum of 0.55 percent in August compared to 0.26 percent in July, with momentum in the services segment having picked up. While automakers have announced price increases, white goods manufacturers are also expected to pass on their higher input costs to the end users.
The fact that the price pressures are getting more broad-based is evident from the Diffusion Index on CPI. As of the August data, 36.7 percent of items in the Headline CPI now show inflation of 4 percent and above, while it was 31 percent in June. June was the last CPI data that the MPC saw as they met in August. Further on the core side, 20.8 percent of items show a 4 percent+ inflation print compared to 15.1 percent in June.
Thus, with the generalization of price pressures, we expect the RBI to hike rates in October by 25 bps. However, we do not expect the stance to change as global conditions remain volatile and uncertain. Further, our inflation projections show that since price increases that will be delivered by manufacturers will be one-time, headline CPI inflation in FY28, especially in Q3 and Q4, could soften to around the 4 percent level. This implies that the RBI’s current hiking cycle will be short – a 50-75 bps increase in the repo rate. A neutral stance will also indicate that the move by the RBI is more a normalization of policy rates than a real tightening.
The only hitch is that liquidity continues to be in surplus even after rounds of Variable Rate Reverse Repo (VRRR), Open Market Operations (OMO) sale of Government Securities and sell-buy currency swaps, and the Weighted Average Call Rate (WACR) ended today at 5.08 percent, way lower than the current signaling rate of 5.25 percent. The concern, therefore, is that in this atmosphere the impact of a rate hike will be lost, and the hanging question is: Will the RBI wait for liquidity overhang to reduce and the WACR to align to the repo rate? This remains a possibility, but waiting until December will risk allowing inflation to rise further and markets to start pricing in a 50bps increase in the December policy.