Changing stance

Fed, ECB decisions leave RBI with a tricky choice

There has been a flurry of central bank action across the world in the past few days. The Federal Open Market Committee (FOMC) of the US Federal Reserve went ahead with an expected policy rate hike in its Wednesday meeting. Across the Atlantic, the European Central Bank (ECB) has stated its intention to end its Quantitative Easing (QE) programme in January, while India’s central bank has announced an enhanced QE of its own from January. The Fed rate hike was the fourth in the calendar year 2018 and the ninth since December 2015. Despite the hike, the US central bank toned down the hawkish messaging; it now projects only two rate hikes in 2019 (as against three expected earlier) as it sees US gross domestic product growth rate easing even as inflation moderates. The ECB will stop its QE, by which it has been buying €15 billion worth of bonds every month; it has thus, injected over €2.6 trillion in liquidity since March 2015. While the ECB will reinvest the proceeds of those bonds as they mature, taken in conjunction with the Fed’s rate hike and ongoing steps of quantitative tightening, this implies a tighter liquidity scenario for hard currencies in 2019. One likely consequence is lower foreign portfolio investor (FPI) commitments to emerging markets. In particular, this could mean sales by foreign portfolio investors (FPI) of rupee debt holdings as well as equity outflows.

The Reserve Bank of India (RBI) has eased the tap on liquidity, but has held policy rates stable despite lower inflation prints. From January 2019, the RBI intends to buy Rs 600 billion worth of bonds every month in open market operations, effectively injecting that much liquidity. The current liquidity deficit in the Indian banking system is estimated at Rs 1.3 trillion and this could be exacerbated by advance tax payments and higher government borrowings, with the fiscal deficit target already exceeded. The central bank will be under pressure to cut rates at the next policy review meeting due in February. The headline inflation rate is down well below the targeted 4 per cent year-on-year trend of the consumer price index (CPI). This is due to negative changes in the food basket (which contributes 46 per cent of the CPI by weight) and moderating fuel prices. So there’s a case for a policy rate cut.

But the RBI also has to worry about the fact that core inflation (that is, ex-food and ex-fuel) is high at about 5.75 per cent and it must track the potential impact of rate changes on the rupee. If the dollar and euro rates go up, as they will, and rupee rates go down, the rupee could experience another bout of weakness as the spread narrows. The dollar may strengthen and continue to put pressure on emerging market currencies in particular on account of the rate hike. This will also affect investors looking at these markets as the currency risk increases. Also, as OMO expansion indicates, there is already a liquidity deficit and, by stimulating consumer demand, a lower rate could lead to an increase in the liquidity deficit. Anyhow, banks with stressed balance sheets may not be willing, or capable, of passing on rate cuts to commercial borrowers. The RBI must consider bond market conditions, rupee movements and changing inflation projections before it can take several momentous decisions.