End of rate cut cycle

The bond market suggests that inflation will stay elevated

Even as the central bank has kept key policy rates unchanged since August, bond yields have surged 70 basis points, suggesting that the debt market is not comfortable with the situation. Investors are seeing surging inflation as a potential threat to a still struggling economy and a daunting challenge to policymakers. Since markets do not like uncertainty, investors seem to have built an expectation hypothesis about where the rates could go, and are adding an “uncertainty premium” to bond yields. What could be the prescription when the inflation rate rises but growth rates are weak? Theoretically, the Reserve Bank of India (RBI) could cut rates to lift growth, but that would fan inflation even further. The problem gets accentuated when the RBI has an explicit mandate to contain inflation within a particular range. This means as long as inflation ranges between 2 per cent and 6 per cent, the central bank’s inflation targeting is working. If, however, prices rise or fall beyond the range for three consecutive readings, the central bank will have questions to answer.

The RBI has kept its monetary policy stance “neutral” for a long time and many analysts expect that most indicators point to rates having bottomed out. Meanwhile, there are no indications coming from the central bank on its course of action except the RBI governor saying earlier this month that it would be strictly data-dependent. The market interpreted the central bank governor’s statement as hawkish and bet on a rate hike eventually pushing up yields. But raising interest rates won’t be an easy call for the RBI, which took advantage of a period of low inflation to cut them by 200 basis points from January 2015 until August.

While the RBI believes that liquidity remains comfortable, the weighted average call money rate, which it targets, is below the policy repo rate of 6 per cent. Sure, the banking system’s surplus liquidity after demonetisation needed to be mopped up through sterilisation bonds of Rs 1 lakh crore. But the RBI’s secondary market bond sales worth Rs 90,000 crore may have pushed the market beyond its comfort zone. The massive cash balance built up by the government, at over Rs 4.5 lakh crore, is also not good news for liquidity and the incessant supply of state government bonds has added to the uncertainty in the market. While foreign investors have hit their investment limit and can’t participate in the auctions, banks, which are India’s biggest bond investors, are losing appetite for the papers as the rise in bond yields since the end of June could bring higher borrowing costs and steep mark-to-market losses.

The central bank needs to act decisively to boost liquidity. With the general elections in 2019, there are strong chances that populist measures will once again weigh on the fisc and keep inflationary pressures on. Cues from global markets are also not very encouraging as the US continues with its rate hikes. This will put upward pressure on bond yields across the world, more so for emerging markets. If short-term rates, which have gone up, continue to remain elevated, longer-term rates too will adjust to steepen the yield curve. That would mean interest rates in the economy have risen to a point of no return, at least for a while. The RBI would need to readjust its policy stance to reflect the reality.