India's central bank has a 'dilemma' ahead of tomorrow's interest rates meeting

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  • The Reserve Bank of India will have to make a difficult policy decision when it meets tomorrow, BAML says.
  • A weaker currency and higher oil prices are putting upward pressure on inflation, although domestic financial conditions are already tight.
  • BAML says there‚Äôs a considerable chance the RBI will raise rates again tomorrow.

The Reserve Bank of India (RBI) will make its interest rate announcement tomorrow, and it faces a policy dilemma.

On one hand, inflation expectations in India have risen sharply — a scenario that typically makes a rate hike more likely.

But at the same time, financial conditions in India are already tightening as markets grow nervous about the economic outlook.

Stocks are down, the Indian rupee keeps falling to all-time lows against the US dollar, and bond yields are rising.

That contrast leaves the RBI with a “dilemma”, Bank of America Merril Lynch (BAML) currency strategist Rohit Garg said. And with that in mind, tomorrow’s meeting “will be a very interesting one”.

Garg said BAML’s economists expect the RBI to stay on hold tomorrow, but he isn’t so sure.

“We believe that there are significant chances for the RBI to hike policy rates this week,” he said.

If the RBI does raise rates, Garg said it could do so in either a “neutral” or “hawkish” manner. And the decision it makes “will highlight the RBI’s bias to the market in terms of it objective and mandate”.

A hawkish hike would either be a 25 basis point rise with an upward bias in the commentary, or a full 50 basis point increase.

Garg said a neutral hike is more likely, which will put more downside pressure on India’s currency. The rupee fell to a new record low overnight following a spike in US bond yields.

The weaker currency has exacerbated India’s inflation problem, because the country imports most of its oil — which in turn has surged by more than 10% over the last month.

“In terms of oil impact, we believe 10% rise in oil causes headline inflation to move higher by about 0.6%,” Garg said.

So while inflation in India is rising it’s being driven by external factors, rather than strength in the underlying economy.

In fact, BAML expects Indian stocks to fall by another 10-12% by the end of the year, with upcoming state elections adding an extra degree of uncertainty.

And to help spur the domestic economy, Garg said the RBI is likely to ramp up liquidity injections through open market operations (OMO).

As evidence, he noted the central bank has forecast its plans to inject around 360 billion rupees in the month of October, when previously it did so in a more sporadic manner.

Regardless of the outcome tomorrow, Garg said he expects the Indian rupee to keep falling. BAML now expects the USD/INR exchange rate to climb above 75 by the middle of 2019.

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