US stopped and India started – Interest rate hikes? Is it a fear of currency war risks?

The month of August was unique in the sense that the US Fed and the RBI announced their monetary policy on the same day i.e. the 01st of August. Interestingly, RBI hike rates by 25 basis points while the Fed chose to maintain status quo. The Fed chief has been talking about a 25 bps hike in September although there is pressure from the US government not to hike rates at a time when the GDP growth is finally coming back to the US. But the RBI appears to be in a slightly different position this time around. Here is why!

Why the rate-hike in August was almost unavoidable…

The general market expectation was that, while inflation was an issue, the MPC may choose to hold the interest rate hike till October. That is because, the final data on the Kharif output is yet to come out and the impact on food inflation will only be known by September. Also, the US Fed announcement will come later and that could have been real trigger for the MPC to decide on rates. The RBI had other priorities. The RBI has been driven more by the fact that while economic growth at the GDP level is maintaining steam, inflation control could be a real challenge. That is more because two of the key triggers of inflation; food prices and crude oil prices are both outside the control of the RBI. RBI is also factoring in the impact of the phased payout of House Rent Allowance (HRA) to government employees could be inflationary. Then there is the geopolitical overhang of Iran, Russia, Turkey and the whole of Middle East and it has an impact on crude oil prices. The impact of higher MSP (Minimum support price) of Kharif is still an X factor. Under these circumstances, the MPC has tried to pre-empt any inflationary risks to the Indian economy. What remains unanswered is whether this is the end of the rate hike cycle. There were some clues that came out when the MPC minutes were announced on 16th August, where the focus was clearly on inflationary risks on the upside as the Iran imbroglio following the sanctions was likely to constrict supply and put pressure on inflation in India.

The real factor could have been the rupee

Scratch the surface the key issue was not so much about inflation but about the constant weakening of the INR. The INR held around 69/$ for a long time, thanks to RBI support. But the rupee fell sharply when the Turkish Lira crisis actually broke out. The 70/$ level has been breached and the RBI looks unlikely to intervene in a big way. The reasons are not far to seek. The RBI forex chest has already depleted by over $25 billion to below the $400 billion mark. Trade deficit in July touched $18 billion and the annual import bill could be closer to $550 billion. With less than 9 months of imports in the forex chest, the RBI may have little choice but to let the rupee fall. The only other option was to hike rates and let the portfolio flows come and automatically balance out the rupee risks.

Currency trading india US stopped and India started   Interest rate hikes? Is it a fear of currency war risks?

What is the road ahead from here?

RBI appears to have front ended the rate hike in August and may hold status quo till end of the year. But you can never be too sure. Further weakness in the INR may force another rate hike by the RBI. The US situation is more complex. Trump wants to keep rates low to finance his trade war and also to keep the dollar cheap. Trump is also keen that US corporations do not end up in trouble with higher interest rates. In the US the battle between politics and central banking may decide the road ahead and more often than not, the politics wins. So we could see the US holding on to rates for much longer.

For starters, the three key financial markets of equities, bonds and currencies have taken the rate hike in their stride. We will have to wait for further macro cues coming in as also the flow of macro data in the form of inflation, IIP, core sector and the GDP data.

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