RBI MPC Preview

The fast-evolving world order and consistent repricing of Fed’s outsized hikes are strong-arming the EMs. This exposes the instability inherent with the classic EM central bank trilemma: one cannot have a stable currency, unfettered capital flows, and independent monetary policy all at the same time. This painful adjustment has not spared the RBI either, which is set to deliver another front-loaded 50bps hike this week. Net cost of a supposed soft signalling via shallow hike could be higher than a larger hike. The hike would also make the ex-post real repo rate positive, but it would be still lower than RBI’s estimated real neutral rate. Liquidity tightness would lead to faster and better transmission, implying that the RBI may not get too restrictive and the terminal rate could hover near the estimated real rates, i.e., not more than 100bps hikes ahead. However, the situation globally is still fluid, and macro assessments might require frequent adjustments ahead from a policy perspective.?

What difference a month or two can make; The world order has changed substantially since the last RBI MPC policy in early August. In fact, August MPC minutes were also read as relatively balanced by domestic market participants. This was partly as the period coincided with relative calm and complacency in global markets on hopes of supposed global peakflation and peak hawkishness of the Fed. This, colliding with global recession fears gathering pace, signalled that the reaction function of central banks, including RBI, would start weighing the growth-inflation trade-off carefully. However, consistently increasing market repricing of the Fed since Jackson Hole, the hot August US inflation print, and Fed’s own terminal rate projections outdoing the upwardly repriced money market expectations have followed a carnage in risk asset classes, with EMs bearing a disproportionate hit.

INR pressure may influence RBI’s decision this time; Markets are now settling into a view that outsized Fed hikes will lead the synchronized global monetary-tightening cycle. Clearly, central bankers globally are confronting the classic ‘trilemma’ of international finance: one cannot have a stable currency, unfettered capital flows, and independent monetary policy all at the same time. This robust DM tightening is strong-arming the EMs, indirectly pressing their assets to offer higher risk premia to the world. India has not been spared here, with concerns on the external front continuing to simmer despite easing global supply chain issues. A domestic-driven economic force, while creating a more favorable growth outlook vs. peers and DMs, will also come at a cost in the form of a wider CAD and higher inflation cycle. India’s massive FX defence amounting to ~US$100bn estimated since October 2021 (spot + forwards) made it an outlier in the Asia FX fall, until recently. However, global FX disorder has meant that the INR’s breach above 80, despite RBI's active FX intervention, is a strong indication of the impending range shifts. Overall pressure on the BoP is likely to lead to more correction for the INR.

The market’s opinion is still divided on 35bps vs. 50bps hike this week. While there are merits in favor of a 35bps hike (nascent credit cycle, limited fiscal impulse, and better transmission amid tighter liquidity to name a few), the net cost of soft signaling could turn out to be higher than that of an outright front-loaded 50bps hike at this point. This could flow via avoidable noise in financial asset classes, which would make the steady state equilibrium even more farfetched. This conscious front-loading could give them some breather next year on shallow hikes ahead. With inflation likely to be largely in line with RBI’s estimates, this week’s 50bps hike will make the ex-post forward real repo rate* positive, albeit still lower than the RBI’s estimated real neutral rate of 0.8-1%. At this point, we still think that the RBI would not go too restrictive and terminal rate could hover near the estimated real rates, implying not more than 100bps hikes ahead, including this week’s decision. However, the extent of global disruption will remain key to the RBI’s reaction function ahead.?

Liquidity tightness implies faster and better past hikes transmission; Banking system liquidity has shrunk to near zero from more than Rs8trn at the beginning of FY23, led by higher currency in circulation, government surplus (currently estimated above Rs3.5trn by September-end), and FX intervention. This has led to a spike in short-term money market rates, now tracking tad higher than repo rate. The tightening in domestic financial conditions combined with external benchmarking system has facilitated faster transmission of rate hikes and will ensure the expected 50bps hike gets well transmitted and reduces the need for aggressive hikes ahead.

Elevated in the near term, but inflation may slide by end-FY23 to 5.3-5.4%. Even as H1FY23 inflation may turn out to be modest 15bps lower than the RBI’s forecast, underlying core inflation still appears sticky around >6% levels. Fall in global commodity prices is a tailwind, but favorable impact is likely to be centered on core goods WPI rather than CPI. Early signs of rising services costs in the economy could be another pressure point. Besides, exchange rate depreciation pass-through (though limited, albeit increasing) could increase additional price pressures ahead, which could partly counter commodity price fall. We maintain FY23 inflation will average close to 6.5% (RBI: 6.7%), while our growth forecast of 7% now has a downward bias, amid global ultrarestrictive policies and impact of front-loaded RBI hikes. This report is intended for [email protected] use and downloaded at 09/29/2022 02:13 PM This report is intended for gaurav.narkar@em