Economy - Government, Fed make bold moves :EDELWEISS

The Indian government’s fuel price hike and US Fed’s launch of QE3 are bold measures, both from macroeconomic and sentiments’ perspectives. For India, the government move trims chances of ratings downgrade and sends a favourable signal to RBI, even though it stokes inflation in the near term. More broadly, the government undertaking a tough political decision sends a strong signal that it is concerned about the worsening macro environment.

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India: Government acts boldly on fuel prices

The government took three crucial steps to address growing concerns over surging under-recoveries. These include: (a) hike in diesel prices by ~12%; (b) cap on LPG subsidy to six cylinders per household; and (c) cut in excise duty on petrol by INR5.3/lt. These steps are meaningful and politically difficult. They send out a strong signal that the government is seriously concerned about the worsening macro environment. Following are the immediate implications from the macro perspective:

·         Risk of sovereign ratings downgrade reduces materially as ratings agencies will derive comfort from the government’s intent to undertake politically tough decisions. 

·         Further, this should be seen favourably by RBI as ballooning fiscal deficit and suppressed inflation were its key concerns. Yet, we maintain that the forthcoming policy review on September 17 will be a status quo, although guidance will be toned down.

·         As regards WPI inflation, we foresee a direct impact of ~50bps and indirect impact of another ~30-40bps on headline inflation due to the fuel price hike.

·         As regards fiscal deficit, the move will help cap the rising oil subsidy burden. At average crude price of USD110/barrel and USD/INR at 55, total under-recoveries, as per our energy team, amounts to ~INR1.45tn in FY13. Assuming government share of 60%, the subsidy burden comes to ~INR870bn (Budgeted:  ~INR436bn). 

US: Fed turns aggressive; announces QE3

The US Fed has announced another round of QE (so called QE3) in its FOMC meeting and substantially increased its commitment to keep the monetary policy highly accommodative in the coming years.

The specific steps are:

·         Fed will make outright purchases of MBS of USD40bn/month till such time the labour market conditions improve substantially. In that sense, the purchase programme will be open-ended. Most likely, it will continue for at least a year as labour market conditions are unlikely to improve substantially as per Fed’s own forecast (see Table1). In quantum as well as guidance, it is an aggressive move, and exceeded market expectations.

·         Further, the commitment to keep the Fed rate at exceptionally low level has been extended to mid-2015 from late-2014.

·         Indeed, the Fed states that the “Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” This shift in guidance is aggressive and unprecedented.

·         In terms of growth projections, the Fed has downgraded 2012 growth forecasts, but has revised up forecasts for 2013 and 2014.

Overall, the Fed is aggressive in its use of balance sheet as well as in its communication/guidance strategy. By lowering mortgage rates, purchases of MBS can lend some support to the housing market, which is already showing some signs of recovery. Notably, a depressed housing market has been one of the key constraints to economic recovery. Therefore, Fed’s steps are positive for the economy, but their benefits will go only so far given that the deleveraging cycle is underway.

EdelFlash: Economy - Government, Fed make bold moves

Regards,