Inflation is still stubbornly above the 6% upper bound of the target range, with August’s reading quickening on a year-on-year as well as a sequential basis. Headline inflation is expected to peak in September and decelerate after that, but a return back into the 2-6% target range is only likely in the March quarter, and even then, readings will still be above the 4% mid-point well into FY24. With the MPC more confident about growth prospects than inflation, it will see merit in frontloading moves. Additionally, departing from the past, just as the policy commentary touched on the health of the external balances in August, we expect a likely doubling in the current account in the June quarter (on nominal and percentage of GDP) to be a matter of concern in September. RBI governor Shaktikanta Das alluded to 50 bps is the new normal at the last review, implying that the room for gingerly paced moves has narrowed in light of evolving and impending risks.
There has been a significant churn in the global policy environment. Since the US Fed’s hawkish recent rhetoric and increase in the terminal rate for this cycle, risk sentiments have weakened considerably, weighing on regional currencies and bonds, complicating policymakers’ inflation fight. Strong intervention presence had kept the USDINR in a narrow range, but the pair have since swiftly risen to record highs above 81.0, i.e., the rupee at a record low.
With the nearly $44 billion drawdown in the forwards book and $90 billion-plus fall in the total reserves stock, upcoming intervention efforts are likely to be opportunistic. The currency will continue to adjust along with the regional peers if the shift is triggered by a wave of broad dollar strength and risk-off sentiments. Nonetheless, this does not take away the fact that the rupee is still among the better performers in the region, and foreign reserves adequacy has not been compromised.
These justifications will be sufficient for the MPC to lean towards a third consecutive 50 bps hike this week. September is unlikely to mark the end of the hike cycle, with our projected path for the end-2022 repo rate to rise 6.25% with upside risks, subject to global developments. The real rate (inflation minus 1Y yield) is gradually edging back to black. Banking system liquidity has meanwhile narrowed considerably, much faster than policymakers had intended. With weak deposit growth also of little help and amid intervention attempts, the door remains open for announcements on the cash reserve ratio, open market operations or variable repo auctions.
Developments outside the policy ambit will also dictate near-term market price action. First is the impending decision on index inclusion. Confirmation of this news will fuel short-term gains in the rupee and bond yields, partly offsetting risk-driven depreciation pressures. Beyond that buoyancy, the prospect that the bulk of the benefits will accrue in FY24, and some part of the flows already front running the news; further currency strength is likely to be kept in check. Past instances have seen the central bank mop up dollar flows in the event of strong foreign interest to bolster their defences via accretion to the foreign reserves. Secondly, the bond borrowing plan for 2HFY23 is likely to stay on track in light of strong revenue collections, but states might step up issuances for the rest of the year after a sharp reduction in the first half. On-demand, banks might have to pare purchases in the midst of a broader pick-up in credit growth. Regardless of sticky long-term yields, a flattening bias will endure as policy and liquidity dynamics keep the short-term rates elevated.
Radhika Rao is a senior economist and executive director, DBS Bank, Singapore.
