Falling in line with the majority of street estimates, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), on Wednesday, decided to hike the key repo rate by another 25 basis points (bps) to 6.50% in the August 2018 monetary policy review.
Here are the key highlights of the MPC’s announcements:
- The repo rate has been hiked by 25bps, taking the official repo rate to a level of 6.50%. It is up by 50bps in the last two months.
- The reverse repo rate (repurchase option), which is pegged at 25bps below the repo rate, was automatically enhanced to 6.25%.
- The marginal standing facility (MSF) and the bank rate, which are pegged at 25bps above the repo rate, were fixed at 6.75%.
- The cash reserve ratio (CRR) remained unchanged at 4% and the statutory liquidity ratio (SLR) remained untouched at 19.50%.
Why the rate hike at this point in time?
The general market expectation was that while inflation was an issue, the MPC may choose to hold off on the interest rate hike till October. That is because the final data on the Kharif output is yet to come out and the impact on food inflation will only be known by September.
Also, the US Fed’s policy announcement will come later tonight and that could have been a real trigger for the MPC to decide on rates. However, the RBI was driven on the fact that while economic growth at the GDP level is maintaining steam, inflation control could be a real challenge because two of the key inflation triggers -- food prices and crude oil prices -- are outside the control of the RBI.
Moreover, the RBI is estimating that the impact of the phased payout of House Rent Allowance (HRA) to government employees could also be inflationary. Of course, geopolitical overhang remains over crude oil prices and the impact of higher MSP (minimum support price) of Kharif is still an ‘X’ factor.
Under these circumstances, the MPC has only tried to pre-empt any inflationary risks to the Indian economy. What remains unanswered is whether this is the end of the rate hike cycle for the year or does the MPC leave room for more rate hikes if the data warrants.
How was the consensus view among the MPC members built?
Unlike the June policy, where the 25bps rate hike was a unanimous decision, the August policy had one vote (Ravindra Dholakia) demanding status quo on repo rates. The macroeconomic backdrop was a key factor in the discussions leading up to the rate hike.
Global trade is expected to take a hit on the back of the escalating trade war between the US and China. China is already showing signs of slowing down with its factory PMI down to just 51 for the month of July. While this is likely to impact global business, the Indian IIP is unlikely to be impacted in a big way.
As a result, the MPC did not see the IIP argument as an impediment to hiking the rates. The reason for the majority votes also stemmed from the fact that inflation expectations have gone up sharply. Check the chart below:
The RBI projection of GDP growth appears to be quite optimistic, but that comes with higher expectations of inflation.
Let us take a look at inflation first.
Excluding the impact of HRA payout, the MPC is projecting the rate of Consumer Price Index (CPI) inflation to average around 4.6% in Q2 and 4.8% in Q3 and Q4 each of the current fiscal and at 5% in the Q1 of the next fiscal. This clearly indicates that inflation is likely to be sticky (this is excluding the likely impact of HRA and MSP shocks on food inflation).
What about GDP growth projections?
The MPC is projecting the rate of GDP growth to average around 7.3% in Q2, at 7.4% in Q3 and Q4 each of the current fiscal, and at 7.5% in the Q1 of next fiscal. The MPC is quite confident that this GDP growth will be maintained irrespective of the 25bps rate hike.
Why are the markets not overly bothered by the rate hike?
It may be too early to gauge the reaction but let us look at the Nifty, the USD-INR conversion rate, and the 10-year bond yield post the RBI announcement to decipher what they are hinting at.
- The Nifty did show a small correction immediately after the rate hike but pared most losses and closed almost flat for the day. The equity markets had factored in two rate hikes this year and may see this as a pre-emptive measure.
- The INR recovered around 10bps after the rate hike announcement. The reason is quite straightforward; the rate hike will act as a counter to the weakening of the rupee which is bearing the brunt of higher inflation. The rupee has almost gained 80bps after crossing the 69/$-mark.
- The 10-year bond yields were expected to harden after the rate hike, but they softened by around 45bps instead. The bond markets are almost expressing confidence that the rate hikes for the year may have been front-ended and there may not be more room for further hikes this year. This, probably, is bringing down the yields.
For starters, the three key financial markets have taken the rate hike in stride. We will have to wait for further macro cues coming in and also for the actual minutes of the MPC, which will be out in the next 15 days. For now, it seems to be business as usual!