Mumbai: U.S. interest rate hikes and the pressure they put on the rupee are likely to give the Reserve Bank of India (RBI) a reason to raise rates by 50 basis points on Friday. This is happening as the RBI tries to protect a growth recovery.
Since May, the RBI’s monetary policy committee (MPC) has raised the key policy rate by 140 basis points, bringing it to 5.4%. Since the last policy meeting, retail inflation has risen back above 7%, and the rupee has lost 9.5% of its value over the past year. Pressure on the rupee has increased since last week’s meeting of the U.S. Federal Reserve.
“Changes in global policy have made people feel a lot worse, which has hurt currencies and made it harder for policymakers to fight inflation,” said Radhika Rao, a senior economist at DBS Bank.
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“Even though rate-sensitive flows are a small part of bond ownership as a whole, the government will want to protect against spillover risks from events around the world,” she said.
Last week, the difference between the yields on 10-year Indian and U.S. bonds hit 360 basis points, which is the lowest it has been since September 2009.
The 10-year bond yield spread between India and the U.S., in basis points https://graphics.reuters.com/INDIA-ECONOMY/CENBANK/klpykxkdopg/chart.png
Based on its dot plot, the Fed Funds rate is expected to rise to 4.6% by the end of 2023. This will make the difference between the policy rates in the United States and India smaller.
The latest RBI poll says the Reserve Bank of India (RBI) is likely to stop raising rates at 6%, but the overnight indexed swaps (OIS) market thinks the rate could go up to 6.5%.
This would mean a difference in interest rates between 150 and 200 bps, which is much less than the long-term average of 500 bps seen from 2002 to 2022.
In a recent note, Deutsche Bank (ETR:DBKGn) said, “Interest rate differences are also important and can’t be ignored, especially while the Fed is in the middle of an aggressive rate hike cycle.”
“Even though the RBI has been intervening in the foreign exchange market, the breach of the rupee above 80 levels leaves room for more depreciation in the coming months. “This is likely to cause minor inflation and would necessitate a 50-bps rate hike at this time,” the bank continued.
One-to-one action is unlikely.
Even though the MPC could consider a bigger rate hike at its September meeting, Vivek Kumar, a senior economist with QuantEco Research, said that rates in India might not rise as sharply as in developed markets during the current cycle.
“For emerging market economies, the difference between interest rates is important. But because the gap between our actual inflation and our target inflation isn’t as big as it is in the U.S., the pressure isn’t likely to lead to a one-to-one response from MPC, he said.
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India’s inflation has been higher than the target range of 2% to 6% set by the MPC for eight straight months up until August.
Kumar said that a rate hike of 50 basis points on Friday was right no matter what the Fed did.
Now that the rupee has passed the psychologically important number of 80, more people are betting that it will keep falling. Analysts think that the RBI will continue to step in by selling dollars to stop the market from moving too much, but rate hikes may also help.
