Could the RBI raise interest rates in the year 2018

The RBI interest rate signals are normally sent out by the Monetary Policy Committee (MPC), which lays out the broad direction of the interest rates in the market. The RBI normally gives out a signal by tweaking the repo rates. Since the beginning of January 2015, the RBI has cut repo rates by 200 basis points. In addition, the spread between the repo rate and the bank rate has been further compressed by 75 basis points. That means; the total rate cut over the last 3 years has been a full 275 basis points. At this juncture, there appears to be a majority view in the MPC that the interest rate cycle may have bottomed out in India. But the big question is whether there is a case for the RBI to hike the interest rates in the year 2018. Or, is it that any RBI rate cut latest news is ruled out? Let us focus on 3 key factors that could be a key determinant or an indicator of RBI rate action in year 2018..

Retail Inflation (CPI Inflation) could be the big factor in the rate calculations..



The chart above captures the CPI inflation over the last 1 year. It is quite clear that after bottoming out at 1.54% in June 2017, the retail inflation has gained nearly 350 basis points in the last 5 months. In fact, the CPI inflation is now above the RBI comfort zone of 4% as laid out by the MPC. But, why has inflation moved up so sharply? Firstly, the Kharif crop was below expectations in 2017 due to below average monsoons. This has led to a sharp recovery in the price of key inputs like vegetables despite the pulses showing negative inflation. The bigger worry is on the oil prices front. Brent Crude is now above $68/bbl and is already trading at a 32-month high. Oil has a strong downstream impact on inflation due to its strong externalities on prices. The next trigger for inflation reduction will only come if 2018 enjoys a normal monsoon and Kharif output gets back to the record levels of 2016. That means inflation could be elevated for another 6 months. High retail inflation hardly leaves any room for the RBI to cut rates. On the contrary, if the rates go up further then the RBI will have a solid case to hike rates and cool inflation at higher levels. There is also a demand-pull angle with more generous payouts of HRA for government employees and greater rural spending.

10-year G-Sec yields have shown a sharp spike in the last 6 months..



The 10-year G-Sec yield is a benchmark reference rate and is normally indicative of inflation expectations. In the last 6 months the yield on the 10-year G-Sec bond has spiked by over 90 basis points from 6.40% to 7.33%. This is clearly indicative of two things. Firstly, it indicates that any sharp fall in inflation is unlikely in the near future in the absence of triggers. High oil prices will also remain an overhang for retail inflation. Secondly, it also indicates that Indian interest rates need to move up to a higher level to sustain the real interest rates in the light of higher average inflation. That is only possible if the RBI hikes rates and that is possibly what the 10-year chart is indicating. It may be recollected that the RBI had cancelled its recent bond auction as it did not find it viable to borrow at such high levels. Despite that clear hint from the RBI, the 10-year G-Sec yields continue to be sticky at higher levels. That is obviously indicating that the market is pricing in a rate hike by the RBI during the calendar year 2018.

It will predicate on what the Federal Reserve will do on the rates front..
The original expectation was that the Fed was likely to hike the Fed Funds rate in 3 tranches of 25 basis points each. However, in Janet Yellen’s last Fed speech she had mentioned about the US economy growing faster than expected, inflation getting closer to 2% and unemployment at a 45 year low. All these are clearly seen by analysts as signs that the year 2018 could see 4 instead of 3 rate hikes. Even the Fed Fund futures on the CME are pricing in the possibility of 4 rate hikes in the calendar year. What does that mean for the RBI stance?

RBI will be keen to maintain the interest rate differential between the US and India to keep the relative attractiveness of rupee bonds. Back in 2013 when the yield gap narrowed India saw FPIs offloading debt to the tune of almost $12 billion. That led to the rupee cracking to Rs.68/$ leading to a series of emergency measures by the RBI. The central bank would surely want to avoid that scenario and let the narrowing gap act as a trigger for risk-off buying by FPIs.

So, what does that mean for the rates scenario?
The next few months’ data flows could be critical. If inflation does not get tamed and if the US embarks on aggressive rate hikes then the RBI may have little choice but to hike rates. We can expect an RBI announcement on interest rates on the upside. Analysts and economists are building an outside possibility of the RBI hiking the repo rates by 25-50 basis points during the year. Anything beyond that could create problems for the sentiments in the market!