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India
Time to tighten: Preview of RBI's rate decision
A rate hike on January 25th is now widely expected, a call we have had for a while. We expect that RBI will raise rates
by 25bps, in line with consensus, but the possibility of 50bps also has to be entertained. However, while the economic
case for 50bps is compelling and it would be a strong signal, RBI is likely to take a gradualist approach given still tight
liquidity, the supply-driven nature of the recent food price spike, and the flexibility afforded by mid-quarter meetings
and verbal intervention through a now more deliberate communication strategy.
The RBI had good reason to be active last year. Growth recovered very quickly after hitting the post-Lehman soft patch. In
turn, this rapidly brought the economy back to potential, tightening capacity constraints and building up demand-led price
pressures as evident from the pick up in core inflation. In addition, food prices did not decline by as much as expected despite
the wet monsoons due to both structural and cyclical factors. More recently, food prices jumped as extended monsoons
destroyed crops. The concern is now that elevated food prices will also spill over to inflation expectations.
With growth expected to remain strong, demand-led price pressures will become more prominent and lift both food and nonfood prices. While the government has announced a number of measures to contain the recent spike in food prices, these are
not expected to make a significant dent in the already elevated level of prices. Rising international commodity prices will also
add to the challenge of containing inflation.
Taken altogether, the case for further tightening is strong. Moreover, monetary policy still remains highly accommodative,
with policy rates below zero in real terms and well-below neutral rates. Also, fiscal policy is not expected to contribute
importantly to demand management. In light of this, the possibility of a 50bp hike should also be entertained. It would add an
element of surprise and, partly because of this, would send a strong signal to the market that the RBI does not intend to fall
behind the curve, a clear and legitimate concern at the moment. Indeed, market chatter about 50bps has picked up, especially
after the RBI governor joked about how other central banks had asked him to give them some of his inflation, suggesting how
"desperate" they were to have inflation while the RBI was "desperate" to rein it in.
Even so, the RBI is expected to choose the more gradualist approach and only hike policy rates by 25bps. Why? Firstly,
domestic liquidity conditions still remain tight, although RBI's stepped up OMOs helped bring down the liquidity deficit from
a high of INR 1700 billion in late December to around 600 billion in early January. However, it has now crawled back above
1000 billion. Secondly, RBI will note that the recent spike in food prices was driven by weather-related factors, which are
outside their control and are likely to have a temporary impact on inflation, although the latter rarely seems to be the case in
India. Thirdly, the shift to more frequent policy meetings has afforded the RBI the ability to take a more gradualist approach.
Finally, the now more deliberate communication strategy could add verbal intervention by being appropriately hawkish.
However, this would also mean that another hike in March would be more likely and that we may need to frontload the profile
for our 2011 cumulative call of 125bps.
Bottom line: The case for tightening is strong and the possibility of a 50bp hike should be entertained. However, the RBI is
likely to go the gradualist route, cognizant of tight domestic liquidity conditions, the supply-driven nature of the recent food
price jump, and the flexibility afforded by the more frequent meetings and verbal intervention through a now increasingly
purposeful communication strategy
India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details �� ��
India
Time to tighten: Preview of RBI's rate decision
A rate hike on January 25th is now widely expected, a call we have had for a while. We expect that RBI will raise rates
by 25bps, in line with consensus, but the possibility of 50bps also has to be entertained. However, while the economic
case for 50bps is compelling and it would be a strong signal, RBI is likely to take a gradualist approach given still tight
liquidity, the supply-driven nature of the recent food price spike, and the flexibility afforded by mid-quarter meetings
and verbal intervention through a now more deliberate communication strategy.
The RBI had good reason to be active last year. Growth recovered very quickly after hitting the post-Lehman soft patch. In
turn, this rapidly brought the economy back to potential, tightening capacity constraints and building up demand-led price
pressures as evident from the pick up in core inflation. In addition, food prices did not decline by as much as expected despite
the wet monsoons due to both structural and cyclical factors. More recently, food prices jumped as extended monsoons
destroyed crops. The concern is now that elevated food prices will also spill over to inflation expectations.
With growth expected to remain strong, demand-led price pressures will become more prominent and lift both food and nonfood prices. While the government has announced a number of measures to contain the recent spike in food prices, these are
not expected to make a significant dent in the already elevated level of prices. Rising international commodity prices will also
add to the challenge of containing inflation.
Taken altogether, the case for further tightening is strong. Moreover, monetary policy still remains highly accommodative,
with policy rates below zero in real terms and well-below neutral rates. Also, fiscal policy is not expected to contribute
importantly to demand management. In light of this, the possibility of a 50bp hike should also be entertained. It would add an
element of surprise and, partly because of this, would send a strong signal to the market that the RBI does not intend to fall
behind the curve, a clear and legitimate concern at the moment. Indeed, market chatter about 50bps has picked up, especially
after the RBI governor joked about how other central banks had asked him to give them some of his inflation, suggesting how
"desperate" they were to have inflation while the RBI was "desperate" to rein it in.
Even so, the RBI is expected to choose the more gradualist approach and only hike policy rates by 25bps. Why? Firstly,
domestic liquidity conditions still remain tight, although RBI's stepped up OMOs helped bring down the liquidity deficit from
a high of INR 1700 billion in late December to around 600 billion in early January. However, it has now crawled back above
1000 billion. Secondly, RBI will note that the recent spike in food prices was driven by weather-related factors, which are
outside their control and are likely to have a temporary impact on inflation, although the latter rarely seems to be the case in
India. Thirdly, the shift to more frequent policy meetings has afforded the RBI the ability to take a more gradualist approach.
Finally, the now more deliberate communication strategy could add verbal intervention by being appropriately hawkish.
However, this would also mean that another hike in March would be more likely and that we may need to frontload the profile
for our 2011 cumulative call of 125bps.
Bottom line: The case for tightening is strong and the possibility of a 50bp hike should be entertained. However, the RBI is
likely to go the gradualist route, cognizant of tight domestic liquidity conditions, the supply-driven nature of the recent food
price jump, and the flexibility afforded by the more frequent meetings and verbal intervention through a now increasingly
purposeful communication strategy
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