The credit policy is probably the most thought-provoking statement during the year as the motivations are subject to various interpretations. The policy is based on the decision collectively taken by the Monetary Policy Committee (MPC) which has now unanimously voted for a rate hike. A rate hike is supposed to counter inflation which has been taken to be the Consumer Price Index (CPI) which was at 4.6 percent for April. The MPC has to target the inflation at 4 percent just like how the Fed or the European Central Bank (ECB) targets 2 percent for their regions. Further, there is a band kept of 2 percent on each end. The question is when does one pull the trigger? Should it be when we cross 6 percent or think that we will cross 6 percent or can it be done anytime that is found suitable?
The significant part of the decision taken on Wednesday to raise the repo rate is that the Reserve Bank of India (RBI) has taken a neutral stance meaning thereby that it expects inflationary conditions to be stable in future until the next call is taken. Further, the inflation rate has been pegged at 4.8-4.9 percent for the first half and 4.7 percent in the second half. This gives the feeling that there should be no more hikes if these numbers are adhered to, which leads to the neutral stance.
The two factors to be watched closely that can upset these numbers are oil prices and minimum support prices (MSP). Oil had gone past $80/barrel and reverted to the $75 level. The Organization of the Petroleum Exporting Countries (OPEC) meet will decide on whether or not supplies should be augmented given that supply from Iran could be affected due to the various bans being spoken of on buying crude from this nation. As the government has so far not been willing to relent on loss of revenue on this score by lowering duty rates, it can be said that if OPEC action does not cool prices in the medium term, then inflation will rise further.
MSP is another factor which causes concern. This is a pre-elections year with some critical state elections on the anvil. There will be a tendency for the MSPs to increase which will impact an upward bias to food prices. So far, food prices have been moderating rapidly to ensure that the headline number is kept low even while core CPI inflation (non-food and non-fuel) is above 5 percent. If this changes, then the RBI fear of higher inflation is well-founded and would prompt further action.
Will higher rates bring down prices? The answer is no, but such action will ensure that real interest rates are maintained as higher lending rates do not cause food or petrol prices to come down.
Will banks increase interest rates? The marginal cost of funds-based lending rate (MCLR) formula takes into account the repo rate as part of the calculation and hence lending rates will increase automatically. Some banks have already increased their lending rates before the policy announcement. Deposit holders would hope for better returns which banks will be keen on providing given that growth in deposits was tardy last year due to low rates offered while debt funds gave better returns. As lending is buoyant to the retail sector, home and auto loans in particular will feel the pinch especially for those who have gone in for floating rates expecting that interest rates will come down.
How about the market? The fact that GSec (Gujarat State Export Corporation Ltd) yields were in the higher territory ever since the last policy gave indications that the RBI could be turning hawkish in stance, indicative that the days of low yields are gone. Higher yields are here to stay and while the 8 percent mark will not be crossed, they will also be data-driven including Fed action, inflation, OPEC meet, government deficit, etc. Therefore, volatility can be expected on this end. In fact the T-Bills –GSec differential indicate that the market may be looking at more rate hikes in this year.
Corporates will find it tougher this year to borrow funds, which may not be good news considering that it was expected that investment will pick up this year. Corporate results indicate that there could have been a turnaround in Q4-FY18 which can be pricked by higher rates as working capital cost will go up. On the positive side however, the goods and services tax (GST) has led to lower level of inventories being held which will reduce the interest cost for companies.
On the forex side, higher interest rates is a collateral advantage for the rupee as there could be some incentive for foreigners to invest now in the Indian bond market with the yields going up. The rupee has come back to the Rs 67/$ level which is good from the risk management perspective with forward rates hovering around 4 percent. Therefore, the concern of negative Foreign Portfolio Investors (FPI) flows this year can get reversed to an extent.
On the whole, the RBI has taken an aggressive stance on expected inflation. Increasing the rates based solely on expectations of higher inflation is a strong signal that the central bank will continue to do so in case inflation increases further notwithstanding the targets being less than 5 percent for the year. Another 25 bps hike can be taken as given with the possibility of two hikes not being ruled out in case conditions get sticky. That is the message which can be taken from the Policy stance.
Updated Date: Jun 07, 2018 08:13 AM