Reserve Bank of India to hike policy rates on September 16

We expect the RBI to hike policy rates by a final 25bp on September 16 (and cut from April on). Yet we do not expect Governor Subbarao to announce a pause next Friday. All the September 16 policy will likely do is scale down the hawkishness of the expected outcome section of the July 26 policy to take greater cognizance of rising global and domestic growth risks as in the August 25 RBI Annual Report.

Base case: Final September 16 RBI rate hike, cuts April

Our base case has the rate cycle peaking with inflation topping off. The RBI will likely pause after a final 25bp hike in policy rates on September 16 and cut 75bp from April onward. If the US double dips, it will likely cut rates faster. In our view, lending rate hikes are almost done after several banks hiked 50bp recently. With high rates biting, loan demand will likely slow more rapidly to 17% by March 2012. This, in turn, should pull down lending rates by 75bp from the slack April to September 2012 season onward. The 10-year should persist in its current 8.0-8.5% trading range. We continue to expect RBI OMO to fund our expected fiscal overrun of 1.2% of GDP. See our rates peaking report here.

“Expected outcome” to be subtly less hawkish

Next Friday we expect Governor Subbarao to indicate that the rate hiking cycle is approaching peak, but leave the door open for an October rate hike if needed. The September 16 policy will likely scale down the hawkishness of the expected outcome section of the July 26 policy to take greater cognizance of rising global and domestic growth risks as in the August 25 RBI Annual Report. The expected outcome of monetary policy was stated on July 26 to be to:
.. reinforce the cumulative impact of past actions on demand;
.. maintain the credibility of the commitment of monetary policy to controlling inflation, thereby keeping medium-term inflation expectations anchored; and
.. reinforce the point that in the absence of complementary policy responses on both demand and supply sides, stronger monetary policy actions are required.

In our view, the coming RBI policy will likely modify the final bullet to acknowledge the need to mitigate rising risks to growth. In fact, the expected outcome section could revert to the June 16 policy’s proposal to:
.. contain inflation and anchor inflationary expectations by reining in demand side pressures; and
.. mitigate the risk to growth from potentially adverse global developments.

Tightening is becoming counterproductive

We do believe that RBI tightening is hitting a stage where it is increasingly becoming counterproductive. Given that much of inflation is “imported,” further tightening could well throw out the baby of growth with the bathwater of inflation. In fact, none of the members of the RBI’s own monetary policy advisory committee supported the 50bp rate hike on July 26.

After all, rising rates have already pulled down growth, at 7.7% in 1H11, below our estimated 8% potential growth rate. Growth likely will also slip below 7.5% in 2H11. This should defuse “overheating” risks. In addition, M3 growth, at 16.4%, is running below optimal 17.5% levels containing demand-led inflation. And, loan demand will likely slip to 17% on rising rates. We assess that the inflationary impact of QE-III, at 50-100bp, will likely be below QE-II’s 150bp as most commodities that Indian inflation is sensitive to face a much more favorable supply-demand balance now. Our US economist, Ethan Harris, now sees a 40% chance of an US recession. See our commodity-wise assessment of QE-III’s inflationary impact here.

RBI will not commit to a pause

Can RBI governor Subbarao commit to a pause in the September 16 policy? Not unless the global situation deteriorates significantly. Although high rates are biting, July industrial growth should post none-too-bad 6.6% – atop 7.7% June quarter real GDP growth – on Monday. Although inflation is peaking, August will likely come in at a still high 9.5% on Wednesday. Even though rates are impacting loan demand, credit growth, at 20.7%, is currently running above the RBI’s 18% FY12 projection.

And, global commodity prices are still holding up in expectation of further US monetary easing. In fact, Ethan Harris sees a high possibility of the Fed announcing Operation Twist on September 21 and a close to 50% probability of QE-III within six months. A global collapse is not set in stone – Ethan Harris expects growth to pick up to 2.3% in 2011 in his base case.

RBI commentary to be less hawkish

Against this backdrop, we expect the RBI to tone down its hawkish commentary. In a sense, we expect the RBI’s September policy to be far closer in spirit to the much more balanced RBI Annual Report published on August 26. We expect a clear acknowledgement of rising risks to the RBI’s 8% FY12 growth forecast from both domestic tightening as well as global slowdown. In the latest

Annual Report, Governor Subbarao recognized downside risks to private consumption demand, on the demand side, and industrial growth, on the supply side, due to high rates. The RBI will likely concede that monetary policy action, however strident, cannot combat supply side inflation, although it could obviously control second-round effects. And the RBI will also likely express its concern about rising global growth risks. The Annual Report has already pointed out that the ability to pump prime out of a global shock has now been circumscribed by a large fiscal deficit.