Unsurprisingly, this has caused Indian markets to gap-up this morning. At the time of writing this, the equity markets have rallied almost 3%, the currency has appreciated another 2.2% from its previous closeand is now 10% stronger than its lows from 3 weeks agoand short-rates have moved down 25-35 bps from their levels before the Fed announcement.
The burning question, therefore, is whether and how the Feds more dovish tone could change the RBIs calculus at the September 20 policy review
JP Morgan had believed that despite the recent gains of the currency and diminished global geo-political risks, the central bank would not risk dismantling the entire interest rate defence (which has led to an inverted yield curve) just as yet. We continue to believe that RBI will not entirely dismantle the rate defence in any knee-jerk reaction to the Fed. Doing so would result in more than a 200 bps cut in short-term interest rates, and we do not believe RBI is poised to take that gamble just as yet, until expectations in the FX markets are anchored more fully.
That said, Indias inverted yield curve does not seem compatiblein equilibriumwith a relatively steep US yield curve. So when the liquidity tightening measures are indeed unwound, they are expected to be accompanied by some increase in policy rates to ensure the reversal is partial, and signal the central banks response to rising inflation pressures. Recall, CPI inflation is still at 9.5% yoy, core CPI is above 8%, and the momentum of headline WPI inflation (quarterly, annualised) is in double digits. Undoubtedly, a lot of this is on account of food shocks, but even the momentum of WPI core inflation has increased by 4 percentage points over the last three monthseven though the level is not threatening just as yet. Furthermore, while the Feds action is supportive of capital flows into India, it already pushing up oil and gold prices which will pressure the current account, and will offset some impact of an appreciating currency on domestic inflation. So some increase in policy rates to accompany the dismantling of the liquidity measureswhen it happensappears likely. And we dont expect RBI to undertake these big changes just as yetdespite the recent rupee appreciation and a more dovish Fed.
Instead, JP Morgan believes recent events may open up some space for a more calibrated reduction of short-term rates. As such, it is possibleeven likelythat RBI will reverse its decision in July that banks will be required to maintain a minimum daily balance of 99% of the cash reserve requirement (CRR), as opposed to the earlier system of maintaining an average daily basis during a reporting fortnight with a minimum of 70% of the required CRR on a daily basis. RBI could also potentially cut the penal marginal standing facility (MSF) rate by 50-100 bps, to provide some relief to short-term market interest rates.
There are expectations in some quarters that banks restrictions on borrowing from the regular policy windowwhich is currently 0.5% of their own net demand and time liabilitiesis reduced. While some easing on that front cannot be ruled out, we believe the RBI will be a little wary of going down that route, until there is more visibility on the quantum of capital flows expected under the recently announced NRI deposits and banking capital schemes. In the event that these schemes attract substantial inflowswhich will necessarily have to be swapped with RBI to avail the subsidy that makes the schemes attractiveit could lead to a significant increase in rupee liquidity. In this scenario, liberalising bank borrowing norms from the regular policy window increases the risk that the interbank call rate could fall by 300-400 bps points for some period of time. Thats why the central bank may be wary of going down this route for now.
All told, the Feds dovish tone does provide some breathing spacebut thats all it really is. Already oil and gold prices are rising and will push up the current account deficit, and thereby offset some of the benefit accruing from the capital account. Furthermore, two weeks after the Parliament session ended, there is no sign yet of a decisive fuel price hike to allay concerns on the fisc, even though the government has reiterated its reseolve on the fisc. Finally, policymakers will realise that some of the rupee appreciation in recent weeks has come from a favourable configuration of global stars (a soft US payrolls number, a dovish Fed, signs of a diplomatic resolution in Syria). Recent history suggests that global risk can turn on a dime. We therefore expect RBI to begin easing policy incrementally from September 20 but not be lured into a knee-jerk over-reaction that could cause some nervousness in the FX market.
The author is senior South Asia economist at JP Morgan