A recent poll of economists conducted by Reuters estimated a 50% probability of a 25 bps rate hike in the October policy. The reasons are not far to seek. The MSP is likely to pressure inflation and Brent crude oil prices are high. A combination of higher fuel inflation and higher food inflation is most likely to give a push to retail inflation, or CPI inflation as we better know. Then there are two more arguments about the Fed hiking rates in September and the rupee weakening. Despite all these arguments, don’t be surprised if the RBI puts rate hikes on hold. Here is why.
Tariff hike indications…
In an innocuous move last week the government hiked the tariffs on 19 non-essential items. While the move is likely to generate just Rs.4,000 crore, it could have much bigger ramifications. Firstly, with the US and China gradually making the WTO redundant, India has an opportunity to solve its balance of payment problems through tariffs. Secondly, government has signified its limitations in using monetary policy as a tool to rectify the situation. The trade deficit is because of consuming too much and not creating commensurate output. The only answer is to curb the demand for such imports through higher tariffs. That is the best tactic that can be used now. In a way, the government has already indicated its preference to shift the balance of payment game from monetary to fiscal tactics.
Rate hikes may work for the US
The argument that India will have to hike tariffs to synchronize with the Fed stand does not really hold water. The US can tighten rates because it is growing at a higher rate than its 20-year average. India is still growing below that average. The dollar benefits from higher interest rates. In the case of India, the rupee has weakened to nearly Rs.73/$ despite two rate hikes in June and August. Clearly, the rate-rupee equation is not working in the same as it works for the US. For India, a tariff hike will have a more immediate impact on the value of the rupee. As we have seen in the past, when foreign investors see the rupee bottoming out, they will automatically come in droves because it makes economic sense. They hardly come due to rate hikes.
Investment depreciation worry
This is perhaps the biggest challenge for the government. Bond yields have gone up sharply in the last one year and banks, mutual funds and insurance companies are already sitting on huge losses (albeit notional). Any further rate hike will not only make cost of credit more expensive, but also trigger a bigger contagion effect of the IL&FS fiasco. Despite what economists think, the RBI may choose to hold rates in October. It could help the government to hit a lot of birds with one stone. We will need to wait for October 05th! ©
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