RBI hikes benchmark lending rate by 25 bps for the first time in four-and-a-half years

Indian Economic Update

RBI Policy: Unanimous hike on the back of growing inflation concerns
The Reserve Bank of India (RBI) hiked the benchmark lending rate by 25 basis points (bps) to 6.25%, for the first time in four-and-a-half years. All the six members of RBI’s monetary policy meeting have voted in favour of a rate hike, while maintaining a neutral stance. Inflation forecasts were raised to 4.8% to 4.9% in H1 and 4.7% in H2 of FY2019. However, the RBI retained the Gross Domestic Product (GDP) growth forecast for FY2019 at 7.4%.


MPC pegs stubborn core inflation as key concern

  • The Monetary Policy Committee (MPC) seems particularly worried about two factors affecting the inflation trajectory, namely, the momentum in core Consumer Price Index (CPI) ex-housing, and the play out of crude oil prices. Both risks were notably flagged by us in the preview for this policy. Monthly momentum for core CPI ex-housing has risen to 0.7% MoM in April from 0.2% MoM in December, contributing in a large way to the sharp rise in core CPI. The Indian crude oil basket has risen by a considerable 14% FYTD (till June 01, 2018). Given the 6% weight of transport in the CPI basket, this development bodes ill for the inflation trajectory.
  • After the earlier policy, we had viewed the slightly lower revision for the H2 inflation forecast as a trifle optimistic, and given the current concerns and uncertainties, expected an elevation in the same at this meeting. This has been justified. While the primary driver behind the more benign inflation outlook in April was controlled food inflation, the chief cause for an upward revision is elevated core inflation. The MPC has continued to flag the risks we had expected, namely, (i) unknown magnitude of the Minimum Support Price (MSP) impact on food prices, (ii) second round effects of House Rent Allowance (HRA) implementation across India, and (iii) rise in household inflation expectations in May. Two of the risks mentioned in the April policy seem to be giving the MPC comfort currently, namely — predictions of normal monsoons and limited concerns on the fiscal slippage front from the Centre or the states. These are expected to keep a lid on inflation concerns.
  • We expect inflation for FY2019 to average 4.7% YoY, with peak in June (5.5% YoY), without considering the impact of MSP. The latest trends in MSP recommendations (for pulses, groundnut and cotton), are showing a more than 1.5X hike in MSP over unchanged (A2 + FL) cost from last year, and if the same trend is extrapolated for the rest of the crops, then the total impact is likely to be at least 60 bps.
  • In other observations, the MPC sounded positive on growth prospects for FY2019, mentioning a revival in investment activity, healthy consumption and near closure of the output gap. The MPC retained its expectation of GDP growth strengthening to 7.4% in FY2019.
  • Measures taken with regards to the Liquidity Coverage Ratio (LCR) is also a crucial development and will help to reduce the sharp rise seen recently in short-term rates. On the development front, the announcement of convergence of priority sector lending guidelines to that of Pradhan Mantri Awas Yojana is welcome, and will help to provide a fillip to the sector and the economy.


Our bearishness on domestic bonds remains in place driven by (i) rising risks around CPI with elevated crude prices, uncertainty about MSP hikes and the rapid closure in the output gap which is leading to a sharp increase in core CPI, (ii) global monetary tightening, (iii) uncertainty on the fiscal front (both Centre and state) in H2 and Goods and Services Tax (GST) collections for the next few months would be crucial, and (iv) demand-supply mismatch in the bond market. Maintaining the stance at neutral seems to suggest that the hike cycle will not be deep and will be primarily data dependent. However, upside risk factors have to be closely monitored. We continue to expect another rate hike over the course of this fiscal year. In the short term, triggers for bonds would be the inflation prints, outcome of the Federal Open Market Committee (FOMC) next week and minutes of the June policy.


Other important developments during the week were

  • India’s services sector activity contracted for the first time in three months in May. The seasonally adjusted Nikkei India Services Purchasing Managers Index (PMI) fell to 49.6 in May from 51.4 in April. The headline seasonally adjusted Nikkei India Composite PMI fell from 51.9 in April to 50.4 in May. 


Global update

US employment report: Unemployment rate edges further down in May

  • The number of jobs added to the US economy in May was 2,23,000 compared to 1,59,000 in the previous month
  • Wage growth increased in line with expectations at 2.7% YoY
  • Unemployment rate dropped further to 3.8% from 3.9% in the previous month
  • Positive surprise in payrolls data and tightening labour market will keep the Fed on track to raise the policy rates in June
  • The Reserve Bank of Australia (RBA) left its policy rate unchanged at 1.5% as per expectations. The RBA spoke about housing credit growth having slowed. The bank expects growth to average slightly above 3% in 2018 and 2019, and has flagged risks from an appreciating AUD slowing economic pickup.


Other important developments during the week

  • After conclusion of latest round of trade talks, China warned the US that any agreement(s) reached on trade and business between the two countries will be void if Washington implements tariffs and other trade measures
  • China said that all commitments on China reducing its trade surplus with the US will progress on the condition that the US does not impose additional tariffs on Chinese imports
  • US Secretary of Defence Mr James Mattis said that the global sanctions on North Korea will ease only if the state makes irreversible and verifiable attempts at denuclearisation
  • The Mexican Government decided to impose tariffs on American products, ranging from steel to pork and bourbon, retaliating against import duties on metals imposed by US President Mr Donald Trump
  • According to sources, Treasury Secretary Mr Steven Mnuchin has urged Mr Trump to exempt Canada from steep steel and aluminium tariffs. Additionally, China has made an offer to buy nearly USD 70 billion of US products if Mr Trump abandons threatened tariffs
  • The European Union (EU) is expected to levy additional duties on US imports from July. EU members have given broad support to a European Commission plan to set 25% duties on up to EUR 2.8 billion of US exports in response to what it sees as illegal US action. EU exports that are now subject to US tariffs are worth EUR 6.4 billion.


Indian equities started the week lower, dragged by financial stocks. Investors’ risk appetite remained subdued ahead of the RBI’s rate decision.

Equities gained as RBI hiked the policy rate by 25 bps on inflation concerns. All the sectoral indices on Bombay Stock Exchange (BSE) gained were led by telecom (3.02%), consumer durables (2.32%), metal (1.72%), realty (1.47%) and power (1.45%) on the day of policy announcement. Sugar stocks were in focus after the Government announced a bailout package for the sugar sector. However, profit booking limited the upside towards the end of the week.


During the week Sensex gained 0.61% to close at 35443.67 and Nifty advanced 0.66% to close at 10767.65.


Government bonds started the week lower as traders trimmed their holdings after reports said that the Government's fiscal situation is seen as challenging and risks to RBI’s CPI targets have increased. Caution ahead of RBI’s policy meet outcome also weighed on prices.

Bond prices also fell as sharp fall in crude oil prices eased concerns of higher inflation. Gilts traded lower as RBI hiked the repo rate by 25 bps, however maintained the neutral stance. Stop losses were triggered as the yield on the 10-year benchmark bond moved above the 7.90% mark. Market sentiments also turned weak post policy decision.


The 10Y benchmark yield ended at 7.94% as against previous week’s close of 7.85%.


Oil prices continued their decline. Crude prices were under pressure due to rising US production and potential increase in supply from Organisation of the Petroleum Exporting Countries (OPEC) and Russia in the coming meet in June in Vienna. According to the US Energy Information Administration (EIA), US crude oil production jumped 215,000 barrels per day (bpd) to 10.47 million bpd in March, the highest on record. According to the US Commodity Futures Trading Commission (CFTC) data, hedge funds and money managers cut their combined futures and options position in Brent for the seventh consecutive week.

Oil prices saw a fresh sell off after a report that the US had requested OPEC to increase supply by 1 million bpd to hit the market. This is close to a 1% increase in global supply, which is being discussed to protect consumers from an over-heating oil market due to the recent outages from Venezuela and potential supply reductions from Iran. The OPEC producers and 10 other nations, including Russia, are to meet in Vienna later this month where the final decision will be announced.
Venezuela raised prospects of halting some oil exports in view of the falling output, which was further aggravated with congestion in the key oil ports of the Latin American country, hindering its ability to serve its customers. The OPEC producer is nearly a month behind delivering its crude to customers due to falling output and congestion in its key oil ports. This was exacerbated after ConocoPhillips seized assets in the Caribbean port of Venezuela, which is hindering the ability to load cargoes and deal with its customers.


Gold edged higher during the beginning of the week. The yellow metal was under pressure due to a rising Dollar, following the strong Non-Farm Payroll (NFP) data release from last Friday. However, growing trade tensions between US and China took some steam off the Dollar and buoyed the metal.

The yellow metal was trading in a tight range as investors turned focus away from the trade tensions to bullish global economic fundamentals, which supported equities and increased bond yields. India’s gold imports plunged a fifth straight month in May to 48 tonnes as a rally in local prices to near their highest level in 21 months curtailed retail purchases.

Gold gained marginally on account of a falling Dollar. The greenback was down due to a stronger Euro which increased for the fourth consecutive day ahead of the G-7 meet in Canada this week, amid high trade tensions.


The Rupee weakened against the Dollar on Dollar buying for importers and overseas investors’ outweighed support from weak Dollar index. Investors remained cautious before the RBI monetary policy meet outcome on Wednesday. Rupee depreciated further on importers’ dollar demand. Buying of Dollar by a few foreign banks weighed on the currency. However, weak Dollar index and Dollar sales by some exporters supported the Rupee.

Rupee recovered some losses on Dollar sales. Dollar index weakness, coupled with positive local equities, also supported the currency. However, the Rupee traded lower on purchase of Dollar for importers and FPI outflows from gilts market.


Source: ICICI Bank Research and Bloomberg.