The month of June will be critical for Indian capital markets for two key announcements. Firstly, there is the Bi-monthly Monetary Policy Review on June 07th. This policy will be closely watched to understand the RBI’s thinking and trajectory on the rates front. There has been considerable pressure on the RBI to push the pedal on rate cuts and the June policy will be a key indicator of the future trajectory of rates in India. Secondly, there is the FOMC meeting coming up on June 14th and 15th, where there are expectations being built of a front-ending of the rate hike. Let us understand how these two critical policy announcements are likely to pan out and what it means for markets.
What to expect from the RBI policy…
The RBI governor has made it clear that the rate action will be largely dependent on the movement of inflation and the transmission of rate cuts to the end customer. It needs to be remembered that since January 2015 the RBI has already cut repo rates by 150 basis points (1.50%). In addition in the last credit policy in April 2016 the RBI also narrowed the band for the bank rate by 50 bps. That means since the beginning of January 2015, the bank rate (which is the reference rate for banks) has been brought down by a full 200 bps (2%). Inflation continues to be a key metrics for the RBI to decide on interest rates. In the month of April we saw the inflation moving up sharply from 4.83% to 5.39% and this surge in inflation was largely led by food inflation and rural inflation. This may coax the RBI to pause because food inflation happens to be sticky as it occurs due to supply-side bottlenecks. Also, the RBI would prefer to see inflation in the range of 5-5.5% on a sustainable basis.
The second issue for the RBI would be transmission of rate cuts. Since the beginning of January 2015 the RBI has cut repo rates by 150 bps but the banks have only passed on 65 bps (less than half) to the end customer. This has largely defeated the purpose of the rate cuts as industry is not getting the full benefit of the rate cuts. To an extent this was possible only once the balance sheets of PSU banks were cleaned up. It is in this light that the Asset Quality Review (AQR) initiated by the RBI needs to be viewed. This quarter, leading PSU banks like BOB, PNB, BOI and Corporation Bank have already written off nearly Rs.25,000 crore in the form of doubtful assets. Once the clean-up is done, the PSU banks will be in a much better position to pass on the rate benefits to the end customer.
What will the Fed do in its FOMC meet?
When the FOMC meets on June 14 and 15, the key item on the agenda would be whether the time is ripe to raise the Fed Funds rate? It may be recollected that the Fed had last hiked the Fed Funds rate in December 2015 to a range of 0.25-0.50% and has maintained status quo ever since. The Fed typically focuses on inflation, growth and employment data to decide on rate trajectory. Unemployment is already at around 4.9% (close to full employment) and growth has been showing signs of picking up. However, inflation is still way below the targeted 2% mark. However, there has been a subtle shift in the review of the April FOMC minutes. The Fed has clarified that more than raw economic data, they will be driven by expected economic data in deciding on rates. This means that even though inflation may be below 2%, the Fed may hike rates if it believes that inflation may inch towards 2% in the future. This is a subtle shift that has happened in the last policy review.
So will the US Fed hike rates and will the RBI cut rates in India?
While the US Fed has surely spoken about focusing on expected data, the majority of votes in the FOMC still seem to be veering towards a status quo. There are quite a few reasons. A rate hike will lead to strengthening of the dollar and that is not good news for US exporters who are already quite unhappy with the dollar strength. Large economic blocs like the EU, China and Japan are still facing a slowdown and the US will not be too keen to upset the applecart. When the Fed last hiked rates in December, global markets lost nearly $12 trillion of wealth along with a sharp spike in volatility. That is a situation best avoided. While the US may look to hike rates in its September or November meet, a hike in the June meeting looks highly unlikely.
Like the Fed, the RBI too may choose to maintain status quo. A sharp rise in inflation as well as PSU banks in a state of flux makes a strong case for status quo. Above all, the Fed meet happens a week after the RBI policy. The RBI governor would not want take the risk of second-guessing what the Fed will do. If the RBI cuts rates and the Fed decides to hike rates (despite a low probability), the RBI may find itself in a rate competitiveness quandary. That is a situation the RBI would surely want to avoid.
In a nutshell, the markets can brace themselves for 2 sets of status quo from the RBI and the Fed in the month of June. It looks like no rate hike by the Fed and no rate cut by the RBI.