Nifty slumped on the concern of faster RBI tightening as India’s inflation jumped

Summary

RBI May Start Hiking From June and May Hike 5-Times in FY23 in Line With Fed

India’s benchmark stock index Nifty closed around 17475.65 Wednesday, slumped almost -200 points from the opening session high on the concern of RBI tightening as inflation surged. On Tuesday, Government (MOSPI) data shows India’s inflation (CPI) jumped +6.95% yearly (y/y) in March, the highest since Oct’20, and much above market expectations of +6.35%. On a sequential basis, the headline CPI soared +0.96% in March, the biggest rate in 5-months, amid surging food and fuel inflation. India’s core inflation also jumped to around +6.40% in March from +5.95% in February. In brief, India’s headline as-well-as core inflation jumped not only well over RBI’s target of +4.00%, but also the upper tolerance levels of +6.00% and RBI’s FY23 forecast of +5.70%.

Looking ahead, India’s CPI may surge more as OMCs (oil marketing companies) refrained from price hikes of transportation fuel (petrol, diesel) and LPG till March and began rising prices from April. If the sequential growth of the CPI index is also around +1%, in line with March, then the yearly reading would come around +7.35% in April.

India’s Central Bank RBI kept its benchmark repo rate (under LAF-Liquidity Adjustment Facility) unchanged at 4% for its April policy meeting, as highly expected. The RBI also left the old reverse repo rate (RR) unchanged at 3.35% (contrary to some market expectations), MSF (Marginal Standing Facility), and Bank Rate at +4.25%.

But RBI introduced a new LAF tool called SDF (Standing Deposit Facility), which is a reverse repo instrument without the requirement of any collateral security (unlike old RR, which requires collateral securities). RBI will now accept excess liquidity (funds) from banks at +3.75% under SDF instead of FRRR (Fixed Rate Reverse Repo). Thus RBI effectively raised the reverse repo rate indirectly and offered a higher risk-free return to banks for their excess liquidity; i.e. banks are now being encouraged to park excess funds with RBI for a risk-free higher return rather than risker lending. This will result in a tighter financial condition.

As there is now excess system/banking liquidity around Rs.8T, it was becoming difficult for RBI to provide adequate collateral securities (GSECS/government bonds) to banks under the normal Reverse Repo (RR) window. Thus RBI introduced a special SDF to absorb excess banking liquidity at +3.75%. In any way, banks were already getting an effective RR rate of around 3.75-4.00% through a dynamic VRRR (Variable Rate Reverse Repo) auction. Thus the overall impact was quite limited. But it may be positive for banks as they will now get higher fixed/minimum returns at +3.75% from RBI against earlier +3.35%. RBI may use the FRRR (Fixed Rate Reverse Repo) tool to absorb excess banking liquidity in the future as per its discretion and evolving financial situation/economic condition.

RBI kept the repo rate on hold for the 11^th consecutive time in April mainly to mitigate any adverse spillover effect out of Russia-Ukraine/NATO geopolitical conflicts/tensions and G7 economic sanctions, which can result in stagflation like a scenario (lower economic growth, higher inflation, and higher unemployment) for the global as-well-as local (Indian) economy. Without naming Russia or Ukraine, RBI said both the countries are important sources of various commodities, the supply disruption of which may result in sticky inflation, especially through prolonged boiling oil above $100.

Although RBI said it’s not hostage to any particular rule book, it’s been behind the inflation curve already for a long period and virtually treating 6.00% of the upper tolerance level as the target instead 4.00%. The Indian economy was already under a stagflation-like scenario (lower economic growth, higher inflation, and higher unemployment) even before COVID. Although RBI never admits it, now it seems that RBI is quite concerned about the stagflation-like scenario because of Russia-Ukraine/NATO geopolitical conflicts, subsequent economic sanctions, and supply chain disruptions. The resultant higher inflation and lower GDP growth may indeed cause stagflation and even an outright recession (after RBI tightening).

It now seems that except for BOJ/Japan, surging inflation is a major headwind for all systematically important global central banks including Fed, ECB, and BOE. Elevated inflation is now a dual issue of higher demand and lower supply. A central bank has only policy tools to control the demand side of the economy (by tightening), not supply (which is controlled by the administration, Lawmakers, and various geopolitical events). Thus RBI may have to also control inflation by slowing down the economy/demand through calibrated tightening without causing an outright recession. So far, RBI was unwilling to slow the economy and control inflation as the focus was solely on economic growth. RBI believes that there is sufficient spare capacity in the economy and thus present ultra-accommodative monetary policy (by Indian standard) is required to ensure growth.

But RBI is now shifting its focus/priority to price stability from growth as uncontrolled inflation will cause lower discretionary (non-essential) consumer spending and eventually result in lower GDP growth. Normally, like all other major central banks, RBI also follows Fed’s actual or even prospective policy action to maintain the real bond yield differential attractive enough, so that angel investors continue to invest in Modinomics (India growth story). But this time, despite Fed hiking +0.25% in March, RBI is on hold in April because U.S. inflation is now around 8% against India’s 6%. The real rate of interest is now around -2% in India against -7.5% in the U.S.

In any way, Fed may hike @+0.50% six times from May till Dec’22, and the Fed rate would be +3.50% by the end of 2022. Fed will also accelerate its QT (balance sheet reduction) @95B/M. Thus USD and US bond yields already soared and going forward, may surge more. RBI has to match Fed and thus may also start the liftoff (gradual rate hikes) from June.

As per Taylor’s rule:

Recommended policy rate (I) = A+B+(C+D)*(E-B) =1+4+ (1.5+0)*(6-4) =1+4+1.5*2=1+4+3=8.00%

Here for RBI/India:

A=desired real interest rate=1; B= inflation target =4; C= permissible factor from deviation of inflation target=1.5 (6/4); D= permissible factor from deviation of output target from potential=0; E= actual core CPI=6

As per Taylor’s rule, which Fed policymakers generally follow, assuming India’s ideal real interest at 1%, the RBI repo/policy/interest rate should be +8% against the present +4.00% to effectively bring core inflation down to the target of +4.00% on a sustainable basis.  

RBI May Start Hiking From June and May Hike 5-Times in FY23 in Line With Fed

But considering the reality of the situation on the ground, RBI may hike to 5.5-6.5% by FY23, depending upon the actual trajectory of inflation, which may surge substantially above +6.00% in the coming days amid higher cost of transportation fuel and food as-well-as core inflation. Thus depending upon the actual inflation and growth trajectory, RBI may start the liftoff by hiking +0.50% in June to match Fed’s +0.50% rate hike action. Then RBI may either hike @+0.25% or +0.50% in the rest of 4-meetings (Aug/Sep/Dec’22 and Feb’23) depending upon the actual Fed rate hike action and inflation.

India is already paying around 45% of its core revenue as interest on a public debt against America’s 9%, Europe's average 4.5%, Japan’s 15%, and China’s 5.5%. Thus India can’t afford too high a bond yield and thus it has to control inflation and RBI has to be ahead of the curve by faster tightening in a balancing way; otherwise, RBI's credibility may be at stake.

On Wednesday, India’s 10Y bond yield made a multi-year high around +7.285% after headline CPI surged to almost +7%. The market is now anticipating an RBI rate hike by at least +0.25% in June and subsequent 3-rate hikes. Higher borrowing costs are negative for equities as corporate earnings may be affected directly as well as indirectly (as discretionary consumer spending will slow under tighter financial conditions).

But any major correction may be also a wonderful opportunity in adversity to invest in well-managed blue-chip companies, that have good/feasible business plans and strong balance sheets. India is now enjoying a scarcity premium among EM markets amid vibrant democracy, geopolitical and policy stability, stable macros, and currency. With the attraction of 5D (demand, demography, democracy, deregulation, and digitalization) along with the mantra of reform and performance, India is now a favorite destination of angel investors.

Looking ahead, whatever may be the narrative, technically Nifty Future now has to sustain over 17800-18000 levels for 18200/18320-18400/18600; otherwise sustaining below 17750, it may fall to 17600/400-17300/17000 and further 16875/16700-16300/15700 in the coming days if Russia-Ukraine/NATO geopolitical conflict further intensifies and Q4FY22 earnings come subdued (after TCS and Infy disappointed).