The Reserve Bank of India’s (RBI) monetary policy committee (MPC) has a tough choice of deciding the quantum of repo rate hike tomorrow as the inflation seems to be moderating in the domestic market, while, at the same time, the US Federal Reserve is well on course to continue with the interest rate hikes from 2.5 per cent to 3.5 per cent by the end of calendar year 2022 to tame the historically high level of inflation.
The MPC, which is expected to announce the monetary policy tomorrow, is expected to vote for a 35 to 50 basis point hike in policy rates.
"In our view, the MPC is more likely to be influenced by the outlook for domestic-inflation growth dynamics, than the size of the Fed’s actions," believes Aditi Nayar, Chief Economist at ICRA.
A Bank of Baroda research report authored by its chief economist Madan Sabnavis states that the average difference in short term policy rates between the US and India ranges between 350-400 basis points historically. After the 75-basis points rate hike by the Fed in July last week, the interest rate differential now stands at 240 basis points, which is actually lower than the long-term average.
"With the Fed expected to raise rates from 2.5 per cent to 3.25-3.5 per cent by 2022 end and a difference of even 300 basis points being maintained, the repo rate should be in the region of 6.25-6.5 per cent by the end of the year based purely on past trends," it adds.
"There is a likelihood of a central bank rate differential between India and US narrowing down from last decade's average. But one needs to look at the cycles while deciphering conclusions," says Akhil Mittal, Senior Fund Manager, Tata Mutual Fund.
"The case of magnitude of rate hikes in front of RBI is slightly more complicated by currency considerations, where I believe India will have to be directionally in line with global central banks, while the quantum of action to be suited for our own economy," says Mittal of Tata Mutual Fund.
Higher interest rates globally will result in dollar outflows in both the equity as well debt markets in emerging markets like India.
Sachchidanand Shukla, Chief Economist at Mahindra and Mahindra (M&M), believes that a high-rate differential may not be as big a worry going forward.
He lists out two reasons. First, given the huge divergence in US vs India inflation differential (i.e. US inflation being 4X of its target vs only 100 bps higher for India) matching rate hikes or a big catch up with US Fed is not warranted. Second, now that the Fed is sounding dovish, and with Powell using words like ‘neutral’ etc., the ‘rate of change’ in the US interest rates is unlikely to be as aggressive going forward.
"It will be the ‘growth differential’ that will start mattering more for capital flows i.e. if India continues to grow at a definite and faster clip, capital flows will start moving back as eventually growth is what investors will look for," says Shukla of M&M.
The foreign exchange cover for imports has been declining as the stock of forex reserves has been slowly declining since September last year. There is also this question of an adequate level of foreign exchange.
Shukla of M&M says that India’s reserves are adequate in terms of import cover. “As against the benchmark of 3 months of import coverage, India has 8 months cover,” says Shukla, who also points out that the ratio of reserves to short-term external debt is also very comfortable.
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