COMMENT | Wary of trampling on green shoots, RBI may tiptoe to August before hiking rates

At its last policy meeting, the Monetary Policy Committee (MPC) of the Reserve Bank of India opted to give the nascent recovery in growth a chance and decided against being an early inflation hawk.

However, a scrutiny of the minutes of the MPC meeting suggested that its members were keeping a beady eye on prices. What followed was a surge in prices of crude oil, a depreciation in the rupee and a surprise increase in core inflation.

No surprise then, that markets believe that a rate hike is imminent and may happen as early as this Wednesday. The yield on the 10-year benchmark government bond has seen a sharp jump, despite a number of recent cooling-off measures.

Source: Reuters

As the MPC deliberates and gets set to announce its decision on Wednesday, the key question that we attempt to answer is how the RBI plans to balance the concerns of nascent inflationary pressure while trying to protect a fragile economic recovery at the same time.

While the street stands divided, we feel RBI might highlight the upside risk to inflation in bold but stop short of a rate hike, leaving a little more time for the early growth momentum to build up.

Inflation – a negative surprise from the last policy

In the previous policy deliberation on April 18, RBI had brought down its inflation forecast to 4.7-5.1 percent for the first half of FY19 (from 5.1-5.6 percent earlier) and 4.4 percent for the second half of the year (from 4.5-4.6 percent earlier).

The emerging data points have disappointed, with the consumer price index (CPI) rising to 4.58 percent in April from 4.44 percent in February. However, of bigger concern is the movement in core inflation (a measure that excludes transitory or temporary price volatility as in the case of food items and energy products), which was hovering in the 5 percent growth band between December and February, but has risen to 5.9 percent in April.

Source: Mospi, Moneycontrol Research

The emerging pressure points

The pressure points are evident. Of late, India's Achilles' heel, which is its large-scale oil import, is becoming more of a trouble than usual. Prices of crude oil touched nearly $80 a barrel, before cooling off because of a possible increase in supply by Russia and Saudi Arabia.

Source: Moneycontrol Research

While the forecast of a normal monsoon might have a sobering impact on inflation, as also the base effect (from July onwards), upward risks to inflation are abound.

Recent outcomes of elections for the ruling Bharatiya Janata Party have been unfavourable. With tough state and Lok Sabha polls scheduled in the next 12 months, a generous hike in minimum support price (MSP) by the government to appease farmers cannot be ruled out.

Since the last policy meeting, the Indian rupee has depreciated by close to 4.7 percent, which exacerbates the inflation picture. With little fiscal headroom to reduce taxes on petroleum products to bring relief to consumers, the government would perhaps prefer a stronger rupee to minimise the damage.

However, a rate hike may have limited impact on the currency as foreign institutional investor (FII) flows remain weak on account of both local factors (banking sector crisis, governance concerns, weaker than expected earnings) and global ones (faster pace of rate hikes in the US).

The fiscal picture, too, has worsened since the last policy announcement. While GST (goods and service tax) collection has been steady after the implementation of the E-Way bill, it has not been robust enough to offset a probable shortfall in other areas.

After the Air India disinvestment fiasco and a weak overall sentiment in the equity market, the projected disinvestment target of Rs 80,000 crore suddenly appears to be a tall ask.

While all this will certainly be on RBI's mind and might force the central bank to drop its "accommodative stance", a formal rate action is unlikely. What we can expect, instead, is a hawkish tone coupled with an upward revision to the inflation forecast. A rate hike could follow at the next policy meeting on August 1.

Tight liquidity – de-facto hike

Liquidity in the banking system is tight at the moment and banks have already started revising their MCLR (marginal cost based lending rates) upwards.

Source: RBI

How strong is the growth outlook?

Although the headline growth picture (7.7 percent GDP growth in Q4 FY18) has grabbed a disproportionate amount of attention, the lower base was a major factor responsible for better GDP performance in the second half of the fiscal.

Source: Mospi

Corporate performance in the final quarter of FY18 was modest, with corporate lenders reporting huge losses, private capital expenditure not visible and consumption being the only engine of growth.