Why India’s central bank may have made a mistake

To the disappointment of markets and against economist expectations, the Indian central bank kept rates on hold, with the policy repo rate at 6.5%.

We think that this will prove a mistake by the Reserve Bank of India (RBI) given the backdrop of general emerging market currency weakness and rising oil prices.

Given the tone of previous meetings and the direction of the rupee and oil since the last policy meeting in August, a 25 bps hike had been widely expected. Evidently the RBI sees things differently, and highlighted the recent softness of food price inflation in its accompanying statement, along with a moderation of longer-term household inflation expectations.

However, as the RBI also noted, PMIs reported an increase in input costs with some evidence of pass-through to the consumer, and corporate expectations of inflation are increasing. Oil has risen around $13 since the August meeting and by even more in rupee terms given the roughly 8% depreciation against the dollar over the same period.

The RBI’s forecast inflation was revised lower, though still above target, while growth expectations were largely unchanged. The case for not hiking was not, to us, overly persuasive.

We wonder if the recent stress in the Indian financial system, with high profile defaults in the non-bank financial sector, may have contributed to the decision. The RBI may have been unwilling to acknowledge it as a motivating factor for fear of the impact on market sentiment.

The one nod to hawkishness was a change in stance, from neutral to “calibrated tightening”, which was not enough to calm currency markets. Unless it is saved by a reversal in oil price and US dollar strength, we think the RBI will be forced to hike at its December meeting.

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