The Fed has surprised markets globally with its dovish stance and tone. Not only did it leave the current run-rate of asset purchases in place, but the interest rate forecasts of 2016 suggest a more gradual hike in rates than markets had anticipated, despite the central bank’s forecast of normalising economic conditions by then. Any tapering is now expected to be pushed back to the December review, at least, with the resulting implication that it may not end by the middle of 2014, as had been previously anticipated.
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 close—and is now 10% stronger than its lows from 3 weeks ago—and short-rates have moved down 25-35 bps from their levels before the Fed announcement.
The burning question, therefore, is whether and how the Fed’s more dovish tone could change the RBI’s 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, India’s inverted yield curve does not seem compatible—in equilibrium—with 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 bank’s 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 months—even though the level is not threatening just as yet. Furthermore, while the Fed’s action is supportive of capital flows into India, it already pushing