India: shock and awe from the RBI as it hikes rates 50bps and signals more to come ::JPMorgan

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India: shock and awe from the RBI as it hikes rates 50bps and signals more to come

Belying market expectations of a 25 bps hike, RBI hikes policy rates by 50 bps and signals there is more to come 1Y OIS jumps 25 bps, bond yields rise 10 bps and the equity market declines by 2 % The RBI concerned that inflationary pressures continue to be higher than expected and that the economy is not slowing enough to reverse these pressures Year-end inflation forecast raised to 7% from 6%, but surprisingly GDP growth forecast maintained at 8% We expect the RBI to increase policy rates by another 50 bps through 2011   RBI rudely shocks the market   Sharply belying market expectations of a 25 bps hike coupled with a signal that the rate hike cycle may be coming to an end, the RBI hiked the repo rate by 50 bps and indicated that it was not done just as yet. Specifically, it noted that a change in stance would only be motivated by signs of a sustainable downturn in inflation.   Markets were clearly not positioned for this hawkish policy action and tone. The IY OIS jumped 25 bps, the benchmark 10 Y government bond yield climbed 10 bps, while the equity market declined by almost 2% on fears that the monetary tightening will be sustained for longer than was commonly believed.   In pursuing a more aggressive stance, the RBI noted that inflationary pressures continue to remain very strong and broad-based and significantly above the central bank’s comfort zone. While indicating that economic activity may be slowing in the first quarter of this fiscal year, the RBI admitted that producers, operating at high levels of capacity, still retain pricing power, implying that activity has not slowed enough as yet to reverse inflationary pressures.   The RBI also admitted that significant global uncertainties exist. The key, from the perspective of inflation in India, however, is how these uncertainties affect global commodity prices. The central bank felt that with no immediate prospect of monetary tightening in most advanced economies, the impact of weakening demand on commodity prices appears to being offset by abundant global liquidity.   Today’s move aimed at anchoring inflationary expectations   Today’s more aggressive action was motivated to anchor increasingly entrenched inflationary expectations in the economy. An upshot of the calibrated approach to rate tightening through all of 2010, in the wake of rising headline and core inflationary pressures, was that inflationary expectations have risen sharply over the last year, as per the RBI’s own survey of households.   By March (the latest round of the survey) households perceived inflation on the ground to be significantly higher than the CPI. More worryingly, inflation expectations have risen consistently over the last year and by March 2011, the 1-year-ahead inflation expectation was close to 13% -- all this while the RBI was raising policy rates.   The move to a more aggressive policy stance both in May and today is likely a renewed attempt by the RBI to retain its inflation-fighting credibility and thereby help anchor inflationary expectations.     There’s more to come   As indicated above, the RBI clearly signaled that a change in its stance would only be dictated by a sustained downturn in inflation. With inflation expected to accelerate over the next few months (as the direct and indirect impact of the increase in administered energy prices filters through) and remain elevated through most of 2011, we expect the RBI will increase policy rates by another 50 bps before the end of the calendar year.   What’s today action has done, however, is provide the central bank the luxury of temporarily pausing at its next meeting in September to assess the impact of today’s sharper move before raising rates again later in the year. That said, if inflation continues to surprise on the upside – after allowing for the impact of the energy price increase – the RBI could well pull the trigger in September itself.   RBI revises up year-end inflation forecast to 7%; keeps GDP growth at 8%   In the May 3 review, the RBI indicated that its year-end (March 2012) inflation forecast was 6% with an upward bias. Indicating that the upside risks to inflation have begun to materialize it revised up its year-end inflation forecast to 7%. Specifically, it cited that the administered increase in energy prices, generous increases in the minimum support prices (MSPs) of key agricultural commodities, and the likelihood that global commodity prices could stay elevated in raising its inflation forecast.   Surprisingly, however, the RBI did not revise downwards its GDP forecast of 8% for this fiscal. Given that the central bank expects inflation to be even more stubborn and elevated, thereby necessitating more monetary tightening, and with global growth risks tilted to the downside, it seemed odd that the GDP growth number was not revised downwards.