Our case is simple. While high inflation is certainly an area of concern, the fact that it is largely concentrated in food and other agricultural items means that monetary action is not the first line of defence. This is not to suggest that the RBI should remain on the sidelines forever – food inflation is known to breed broader inflation expectations and have a second round impact on other, more ‘core’ items.
However, the fact that it has not spilled over yet is likely to mean that the RBI could wait a trifle longer before moving especially since there are equally strong concerns about whether the current economic recovery will sustain (more on this later).
Our bet is that the RBI will wait until December-January period when inflation actually spikes up before changing policy rates. Interestingly the last two inflation releases came in quite a bit below market expectations that came on the back of a sequential moderation in primary product prices. If the central bank is indeed looking for reasons to delay its exit from its super-accommodative monetary stance, the recent inflation prints certainly gives it one.
Second, the jury is still out on whether the IIP prints for June-August represent the beginning of a sustained recovery. Sentiment is clearly up but whether the better-than expected numbers reflect frantic pre-Diwali inventory re-stocking remains an open question at least for us and likely for the RBI as well.
Besides, indicators that have known to coincide with the growth cycle such as credit (even if we factor in commercial paper and bond issues) and exports remain sluggish. Again, we are not ruling out the possibility that we have (somewhat unexpectedly) climbed out of the bottom of the industrial cycle – however we believe that the RBI will need more confirmation before it
Some ‘indirect monetary tightening’ is likely though over the next couple of months. For one, the RBI could reduce the quantum of OMO purchases form the market. Second, the RBI is unlikely to intervene aggressively in the FX markets as intervention would add to local liquidity.
Thus if capital inflows continue to be robust, we expect some more appreciation in the INR. Currency appreciation is at least theoretically known to counter inflation and if indeed supply management in local commodity markets involves importing things that are in short supply, an appreciating currency helps to bring effective import prices down.
If the RBI does move in December/ January, is it likely to signal the start of an aggressive rate hike cycle? We think that is unlikely. It is important to recognize that the increase in inflation in December-January will be essentially a ‘spike’ driven by a low base and a rise in agricultural product prices.
Inflation will subsequently moderate in the second half of 2010 as the base effect works favourably and if the winter (rabi) crop is better, this will help as well. Anecdotal evidence suggests that the bulk of the manufacturing sector is working well below full capacity utilization and price-pressures are unlikely to build up in a hurry. Our assessment is that a significant demand driven price spiral is likely to build up before 2011. Thus while the RBI needs to be vigilant, it is unlikely to hike aggressively.
Finally, the path of bond yields has of late tracked expectations of changes in the norm for the fraction of government securities in the held-to-maturity category (HTM currently at 25 per cent of net demand and time liabilities). We do not expect any significant change in these norms in the policy; that indeed seems to be the market consensus as well. Current levels of bond prices/ yields appear to have priced in this expectation.
Besides the bond market is known to get pre-policy jitters and a small probability of rate action is likely to be priced in as well. Thus if there is status quo in policy and no action on HTM ( as we predict), the market is likely to see a small rally that could take the 10 year bond yield down to 7.25 per cent. We like selling into any rallies.
The combination of fears of high inflation, future rate action and a high deficit will play on the market’s mind and a brief rally is likely to be followed by another up-tick in yields. We reiterate our forecast of a spike in yields in December to the 7.5-7.75 range followed by some moderation by March 2010.