By Aditi Nayar
After a gap of 10 months, CPI inflation declined year-on-year (YoY) below the Monetary Policy Committees (MPCs) medium-term target of 4.0 per cent, easing considerably to 3.7 per cent in August from the recent peak of 4.9 per cent in June 2018. We expect the forthcoming data to reveal that CPI inflation remained sub-4 per cent in September as well.
However, rising apprehension about the impact of the impending US sanctions on Iran have led to a surge in global crude oil prices in recent weeks, as hopes of an increase in supply by the Opec countries have faded.
Moreover, a considerable depreciation in the rupee relative to the US dollar has led to a sustained increase in prices of domestic fuels as well as the landed cost of various imports, posing a key inflation risk.
The cumulative volume of the south-west monsoon rainfall in 2018 stood at a below-normal 91 per cent of the long period average (LPA). Additionally, rainfall distribution was uneven, with considerable geographical and temporal disparities, which is unfavourable for bond yields and crop prices. In line with such trends, the first advance estimates (AE) of crop production signals a year-on-year (YoY) drop in kharif output of cotton, coarse cereals and pulses relative to the fourth AE for the previous year.
Delayed withdrawal of the south-west monsoon may postpone the timing of the kharif harvest and rabi sowing activities. However, healthy reservoir levels across the country would facilitate a brisk pace of rabi sowing once it commences.
Overall, an uneven monsoon, looming impact of revised minimum support prices, a surge in crude oil prices and weakening of the rupee would push up inflation in the second half of FY2019. We expect the headline CPI inflation to range between 4.6 per cent and 5.0 per cent in Q4 of FY2019. As a result, we expect a third consecutive rate hike in October 2018 policy review, along with a change in monetary policy stance.
A change in the stance to withdrawal of accommodation would signal the possibility of another rate hike in December, unless key inflation risks such as crude oil prices and rupee ebb appreciably in the intervening period.
Reflecting various concerns, the 10-year government security (G-sec) yield had risen from 7.70 per cent on August 1, 2018 to 8.23 per cent intra-day on September 12, 2018, before easing to 8.02 per cent on September 28, 2018. The latter partly benefitted from the announcement of open market operations (OMO) of purchase of G-sec of Rs 20,000 crore by RBI in September 2018, the markets expectation of a pipeline of such OMOs in the remainder of this financial year to ease the tightness in systemic liquidity, and moderating expectations regarding the size of the Government of Indias (GoIs) market borrowing calendar for the second half of FY2019.
The after-market hours announcement on September 28 of the GoIs gross borrowing of Rs 2.47 lakh crore for the second half of FY2019 was in line with expectations, following an upward revision in small savings interest rates announced recently.
This was followed on October 1, 2018, by an announcement by RBI that it would infuse durable liquidity through OMO purchases for an aggregate amount of Rs 36,000 crore to be conducted in three tranches in October 2018. This announcement further cooled bond yields, despite the high likelihood of a rate hike in the forthcoming monetary policy review, as well as continued hardening of crude oil prices.
The 10-year bond yield is expected to range between 7.95 per cent and 8.05 per cent in the immediate term. Subsequently, domestic factors such as the outlook for inflation risks including MSPs, crude oil prices and the rupee, their attendant impact on monetary policy, the likelihood of continued OMOs in the rest of the second half of FY2019, as well as the emerging information on the balance of various fiscal risks would guide bond yields.
(Aditi Nayar is Principal Economist with ICRA. Views are her own)