Today’s policy decision suggests that the RBI seems to be taking a long term view on inflation rather than remaining purely data dependent. The discussion on the possible increase in inflation early next year (Estimate of Q1 2019-20 to 5%) as well the assertion that policy rate changes impact the real economy with a lag (with a shorter lag in transmitting to lending rates) corroborates this.
Also, RBI’s statements on increasing external risks and discussions on currency contagion (currency war) in the press conference, confirms our belief that the RBI is not in favour of excess depreciation and seems to want to hold on to a certain exchange rate level. A rate hike is a textbook method of defending a currency.
Given the upside risks to inflation, discussed extensively, another policy rate hike cannot be ruled out. However, if there is an escalation in trade war risks and a resultant global output compression then the RBI could be prompted to stay on a prolonged pause.
The RBI committed that liquidity conditions would be maintained close to the neutral level. This means the supply side pressures in the second half of this year could be offset by OMOs but it is unlikely that we will have any liquidity surplus. We expect OMO purchases to the tune of INR 800 bn in 2018-19, including INR 300bn done so far.
The bond market seems to have reacted in a positive way to the rate hike (declinein 10 year yield by 6bps). This we believe is in response to the RBI’s commitment to keep the liquidity situation neutral instead of allowing the system to move into a large deficit.
We believe, that another rate hike is still on the table and as a result bond yields could continue to go up (after today’s relief rally). In this regard, it’s important to watch out for the inflation readings in September and October (which could be reflective of the impact of higher MSPs). Even without a major uptick in inflation, the sheer supply of government bonds (states and centre) could keep the yields elevated. Important to note, so far only 20% of the budgeted borrowings for centre and state governments has been done with majority of the supply expected to come in the second half of the year.