Crude oil falls to $94, easing pressure on RBI ahead of December policy

The fall in crude oil prices to around $94 a barrel has prompted markets to scale back expectations of the Reserve Bank of India's (RBI) rate-hiking cycle, with investors now pricing in cumulative increases of around 75-100 basis points, delivered in 25-basis-point increments at individual policy meetings. The shift comes as the possibility of a prolonged conflict in West Asia recedes, easing concerns over India's oil import bill, imported inflation and pressure on the rupee. The change is significant for monetary policy because crude prices were among the factors raising the risk of a more aggressive RBI response.

A sustained decline would reduce the need to use interest rates to contain currency pressure and imported inflation. However, it does not eliminate the case for further hikes. Domestic food inflation remains a concern, and the RBI is also seeking to keep the real policy rate positive. Market expectations have already adjusted. According to Gaura Sengupta, chief economist at IDFC First Bank, expectations of a 50-basis-point hike in December have moved towards 25 basis points. Expectations of cumulative rate increases over the following year have also declined from around 100 basis points to 75 basis points.

Lower oil prices reduce pressure on the rupee Brent crude has retreated from levels above $110 a barrel as markets reassess the risk of a prolonged US-Iran conflict and possible disruption to oil supplies. Hopes of de-escalation have reduced the geopolitical premium in prices, although a resolution remains uncertain. For India, the implications extend beyond the fuel import bill. Higher crude prices increase demand for dollars to pay for imports, add to the current account deficit, and can weaken the rupee. A weaker currency, in turn, makes imported commodities more expensive, adding to inflation and potentially requiring the RBI to respond through tighter monetary policy.

Abhishek Upadhyay, economist at ICICI Securities, said the peak in crude prices could be lower than markets had anticipated earlier. "The peak for crude prices could be lower than what was feared earlier. If prices do go up from here, there will still be confidence that ultimately the direction is lower. So to that extent, it is positive fundamentally for India," he said. A sustained decline would also limit the increase in the government's fertiliser subsidy bill, reducing pressure on its finances. RBI has more room on currency defence Lower oil prices could also reduce the need for the RBI to use monetary tightening to support the rupee.

The central bank's October measures to curb importer dollar demand and its foreign exchange interventions have already helped reduce volatility. Sengupta said the measures had been effective. RBI's net dollar sales fell to $700 million in the week ended October 23, against $8-10 billion a week after the special swap windows were closed. She expects the latest foreign exchange reserve data to show a similarly low level of intervention. With currency pressure easing, the immediate need for a larger rate increase has reduced. "The need for RBI to do something big in terms of interest rates has now subsided,"

Sengupta said. She nevertheless expects a 25-basis-point hike in December and cumulative increases of 50-75 basis points, including that meeting. Food inflation keeps the RBI on a tightening path The moderation in imported inflation does not address the domestic sources of price pressure. Sengupta expects inflation to average around 5.2 percent, with October inflation potentially touching 6 percent, largely because of food prices. She said retail fuel prices have risen by only around 5 percent despite the increase in global crude, as the government and oil marketing companies absorbed much of the shock.

Retail prices are also unlikely to fall immediately, as oil marketing companies would need to recover part of their losses. Food inflation remains a concern, particularly with El Nino-related risks still present. "The RBI is hiking interest rates to ensure that the real policy rate stays positive. They are not hiking interest rates to curtail domestic demand. We do not have a demand-led inflation problem. We have a supply-led inflation," Sengupta said. This explains why lower crude prices may moderate the pace of rate increases without necessarily changing the direction of policy. Terminal rate estimates remain at 6-6.25 percent The terminal rate is the level at which the RBI is expected to stop raising interest rates in the current cycle.

It is closely linked to expectations of cumulative hikes: if markets expect more increases, the projected terminal rate rises; if the expected number or size of hikes falls, the terminal rate can come down. Upadhyay said market pricing of the terminal rate in the overnight index swap market had declined from around 6.75 percent to 6.25 percent. However, he continues to expect the terminal policy rate to reach 6.25 percent until there is greater clarity on developments in West Asia. Kanika Pasricha, chief economist at Union Bank of India, sees the terminal rate at 6 percent. Upadhyay said a stable rupee and an improvement in capital flows, including foreign direct investment, would give the RBI more room to calibrate its response.

He also cautioned that overnight rates could rise by more than the policy rate as liquidity conditions tighten. For now, lower crude prices have reduced the market's expectation of how much the RBI will need to tighten. Whether this translates into a lower terminal rate will depend on how long oil prices stay around current levels, the trajectory of food inflation and the stability of the rupee.