Central Bank Watch: Hawkish but hike not yet

The Reserve Bank of India is likely to keep the repo rate unchanged at its upcoming monetary policy review on April 5^th. Despite downside surprises in the recent inflation readings, the RBI is likely to stay hawkish on account of two factors. One, there could be caution related to higher Minimum support prices (MSPs) that the government could offer to farmers in line with its budget ‘commitment’ and because of surging oil prices. Second, core inflation has become more broad-based and is markedly high for categories like services. Increase in components of salaries (like housing allowance) due for employees of the state governments could add to these pressures.

We would also parse the commentary carefully for the RBI’s assessment of global risks such as an economically costly trade war between the US and its major trading partners, comments from the White House on dismantling or diluting trading arrangements like NAFTA, regulatory push-backs in industries like tech on the back of the recent controversy on data leaks, and finally geopolitical tensions with Russia and China (likely to flex their muscles) and the US taking a harder line on Iran and North Korea. This may or may not directly lead to a change in monetary stance but the central bank’s view on how prepared the domestic economy and markets are to face these risks become important.

Change in the outlook of oil prices and emergence of new risks on the international front (trade-war etc.) could have a direct bearing on our exchange rate assumptions as well. We no longer expect the marginal degree of appreciation (Q2 vs. Q1) that we had previously pencilled in. We now expect the USD/INR pair to trade in the range of 64.5 – 65.5 in the short term.

Inflation Dynamics

In the February meeting, the RBI had revised its inflation forecast for the fourth quarter (2017-18) to 5.1% from 4.3%-4.7% earlier. Inflation print is now expected to be lower than the RBI’s estimate in Q4 (so far the average has been 4.8%).

Going ahead in FY19, CPI inflation could inch-up to around 5.6% in June. We expect average inflation of 5.1% in H1-FY19 with much of the rise likely to be on account of an adverse base. Thereafter, in 2H-FY19, while the base effect could be favourable and lead to some moderation in inflation, a lot would depend on how other factors pan out. Price of crude oil, potentially higher minimum support prices, the impact of housing rent allowance increase by several state governments, besides the performance of monsoon are some risks that could emerge in 2H-FY19, warranting a reasonable degree of caution by the RBI.

Given the recent softer inflation prints while the RBI can afford to wait longer and maintain status quo, eventually, we believe, that elevation of some of the upside risks along with the revival in rural demand could lead to a rate hike by the last quarter of 2018-19. Upside risks to inflation are detailed below:

1. Core inflation pressures building up

• Rising core: Core inflation (excluding food, fuel and petrol and diesel) has been sticky in the past three months, remaining unchanged at 5.1%. Prior to this, it had gradually risen from 9% in June 2017 to 5.1% in December 2017.
• 46% of the items in core are rising versus only 9% last year: Our analysis shows that between June 2017 and February 2018, 46% of the core items have seen upward pressures while 45% of the items have remained sticky. Only 9% of the items have seen a fall. This is in contrast to the trend seen between May 2016 and May 2017, when only 9% of the core items were rising while 44% of the items where seeing a downward pressure.
• Upside pressures led by housing, health, items in personal care and effects and recreation and amusement. The rise in core has been led by a pickup in housing inflation (higher HRA for central government employees). However, it is all not just about housing. If we strip out housing inflation, core inflation stands at 4.4% in February compared to 3.7% in June 2017. This signals that the upside pressures are much more broad based.
• Services inflation is leading the upswing, rising to 5.7% in February from 4.4% in the beginning of the financial year (April 2017). This indicates that any downside pressures due to the introduction of GST on service prices, as was expected, has been offset by other core items or has not filtered through to retail prices.

46% of the core items are seeing an upward pressure

Service inflation has been risen more than manufacturing

2. Return of oil pressures: Crude oil prices posted their biggest weekly gain in eight months with rising geopolitical risk in the Middle East and Saudi Arabia hinting that the current OPEC output cuts could be extended into 2019. International benchmark Brent crude gained 6.6% during the past week, briefly reaching $70.58 and currently standing close to $69.68/bbl.

• Oil market continues to tighten: Possibility of an extension of cuts in oil supply till 2019 put upward pressure on oil. Saudi Arabia Energy Minister Khalid Al-Falih said that OPEC & non-OPEC need further coordination on oil supply in 2019.
• Likely return of sanctions on Iran from the US: Prices also got a boost as investors started to price in an increasing possibility that the US could withdraw from the historic Iran nuclear deal, which could bring back sanctions on the country and limit Tehran’s capability to export crude oil.
• All these developments are certainly bullish for oil and we have revised our oil call to an average $68/bbl. for 2018 from $65/bbl. estimated earlier. We still remain conservative on our call as there are still a few unknowns: 1) It is important to consider that Saudi Arabia is not the OPEC’s only member, and it remains to be seen whether everyone will be on board with yet another extension of the cut-backs, especially with prices still on the rise, 2) We continue to believe that booming US shale oil production could potentially somewhat slowdown OPEC’s effort to end a supply glut.

3. MSPs risk: In the Union Budget 2018-19, the government had announced that MSPs will be set at 1.5 times the cost of production. The impact of this increase is dependent on the definition of cost used. Recently, Prime Minister Modi indicated that the cost of production will include labour costs, costs incurred on animals, machinery, seeds, irrigation, fertilisers and land revenue paid. This measure is close to the A2+FL costs reported by the Commission for Agricultural Costs and Prices (CACP).

• According to our estimates, a 1.5 times increase over the A2+FL costs could lead to a 50- 60bps increase in headline inflation. The RBI has also highlighted the increase in MSPs as a key risk in the past and are likely to reiterate the same in the April 5 policy meeting. That said, the RBI is likely to wait and watch before the final decision on MSPs is announced in May this year, before making changes to its stance or forecasts.

Global Dynamics

Change in the outlook of oil prices and emergence of new risks on the international front (trade-war etc.) could have a direct bearing on the exchange rate assumptions and thus on the overall monetary policy equation of the RBI. As per our earlier call, we had pencilled in marginal appreciation for the rupee in the April-June quarter (Table 1). This was assuming that oil prices would average around USD 65/barrel in 2018. Moreover, we expected that markets, by March-2018 would completely price-in all the rate hikes by the Fed for the year.

We now expect the rupee to remain broadly unchanged in the second quarter, similar to the trading range we witnessed in 1Q-2018. This would be primarily because of change in our assumption about oil prices and if some of the risks that we have discussed earlier were to pan out, it could lead to a temporary risk-off in global markets that would in the very short term favour the USD. While we believe that the Fed would hike rates twice more this year, the markets seem yet to be fully convinced that one more hike could follow and any data flow that supports a more hawkish stance could lead to short-term USD gains. However we would like to emphasize that given the balance of risks we remain medium term bears on the USD.

Table 1: USD/INR forecasts

1. Monetary tightening: There is uncertainty on the timing and the pace of normalisation of monetary policies globally. The Federal Reserve raised interest rates by 25 bps in its March monetary policy and forecasted at least two more hikes for 2018. Now, given the pickup in growth momentum and recently announced tax cuts, there is a high likelihood that the US Fed could even go for three more rate hikes in 2018, in which case the pressure could come on Indian bond markets and the rupee. Similarly, while the markets are divided at the moment, there is a growing possibility that the Bank of England could hike policy rates in May and then again in 2H-2018, leading to outflow of portfolio capital from emerging markets in general.

2. Trade war risk: While the countries including the US and China seem to be taking a softer stance on various issues, the risk of higher tariffs cannot be ruled out. We believe that the decision on tariffs on Chinese imports might be part of political tactic ahead of the upcoming mid-term election (US) in November and thereafter the risk could fade. However, for a major part of the year, the market volatility is here to stay, a factor that any central bank would find tough to ignore.

3. Higher regulation and increase in compliance cost: There is a growing sense that more regulation in the tech sector could increase compliance cost significantly and lead to volatility in the global equity markets. In such a scenario, there could be added pressure on emerging market currencies including the rupee.

Bottom-line: Despite the downside surprises on inflation (January and February), there are risks that the RBI cannot ignore. In the short-term, while the RBI will have the room to test these upside risks (1.5 times MSPs, higher HRA by the state governments and rising oil prices), eventually a rate hike would be warranted in our view. Meanwhile, there are global factors that the RBI needs to watch out for, and perhaps act during phases of extreme volatility. Rupee movement in 2018 is likely to be marginal in our view but it’s important to keep a tad of exchange rate risks in an environment of tightening monetary policies globally and rising concerns of a full blown trade-war. Therefore, a status-quo for the major part of the year is the most likely scenario for the RBI. The rate hike could happen in the last quarter of FY19.

Treasury Economic Research team of HDFC Bank

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