SBI Ecowarp Report: First Rate Hike Likely at June Policy Meeting; 75 cumulative basis points expected throughout the cycle | India is blooming


New Delhi: CPI inflation jumped to 6.95% on an annual basis in March 22, from 6.07% in February 22, mainly due to food price inflation.

Inflation rates are now expected to remain above 7% until September. Beyond September, inflation impressions could fluctuate between 6.5% and 7%.

Our FY23 inflation forecast is now closer to 6.5%, given the possibility of a prolonged food price shock.
The Russian-Ukrainian conflict had a significant impact on the path of inflation.

The latest inflation print for March 22 shows that wheat, protein products (chicken in particular), milk, refined oil, potato, peppers, kerosene, firewood, gold and LPG contribute substantially to overall inflation.

The dispute has caused chicken prices to spike sharply as chicken feed imports from Ukraine are disrupted.

Pressure on sunflower oil supplies from Ukraine has led to a change in Indonesia’s export policy, leading to a decline in palm oil imports.

Additionally, the war exacerbated concerns about crop losses in South America, which impacted soybean oil supplies.

Milk and refined petroleum prices also jumped significantly. Surprisingly, the contribution of gasoline and diesel to headline inflation has declined steadily since October 21, while there is a steady increase in the weighted contribution of kerosene and firewood to headline inflation.

We also note a drop in the weighted contribution of LPG to overall inflation.

It looks like fuel consumption went down before the omicron even took hold and the trend towards other fuel sources like kerosene and even firewood might have picked up momentum and maybe will gain even more ground in the days to come. This does not bode well for rural demand.

We have already taken the impact of this pass-through from WPI food inflation to CPI food inflation while estimating our average CPI of 5.5% to 6% (oil price $95-$100 a barrel).

However, an additional factor could increase the risk of upside inflation over the next fiscal year. There has been an increase in the prices of various inputs used in agriculture.

The cost of production should increase by about 8-10%. Thus, the CACP will need to consider this higher cost of production when estimating the minimum support price (MSP) for FY23.

Generally, the recommended MSP is calculated as 150% of the cost of production (A2+FL). The increase in MSP has been in the range of 3-5% in the past. In FY23, MSP should at least be about 12-15% higher.

According to our estimates, inflation will remain above 7% in H1 and 6.5% in H2.

US inflation is expected to reach 6.6% over the next year, according to the New York Fed survey in March.

Fed officials reached a consensus at their March meeting that they would start reducing the central bank‘s balance sheet by $95 billion a month.

The Federal Reserve should therefore proceed with two consecutive interest rate hikes of half a point in May and June to fight galloping inflation.

Historically, at the lower end of the spectrum, the gap between Repo and G-sec has hovered around 250 basis points. In a cycle of interest rate tightening, the spread rises to 350 points. Benchmark 10-year yields should move towards 7.50%, even with the current repo rate at 4%.

We now expect a rate hike of 25 basis points each in June and August, with a cumulative rate hike of 75 basis points in the cycle. As the spread between G-sec yields and repo rates increases in a rising interest rate cycle, G-sec yields could reach 7.75% by September.

We believe RBI will keep G-sec yields capped at 7.5% through unconventional policy measures.

The current jump in yields is also tied to Friday’s RBI circular. In principle, in order to make the SDF attractive and put it on par with the Reverse Repo facility with regard to the maintenance of the SLR, RBI has made deposits placed under the SDF an eligible asset for the maintenance of the SLR.

Thus, from the Bank’s point of view, the SDF facility offers a higher return without compromising the maintenance of the statutory ratio and minimal risk exposure (the counterparty being the central bank). As funds deposited under the SDF are eligible to be considered for SLR, we do not envisage the introduction of this facility to cause additional demand for SLR securities.

That could mean yields in uncharted territory if the RBI doesn’t cap it. As expected, technically speaking, a move to 7.5% and beyond for G-sec yields could be fast and fast as seen now.

The recent spike in benchmark yields lays bare the growing disconnect and divergence between benchmark yields and bank lending rates, with banks entering new territory where lending rates are now effectively below yields, dispelling the risky loans for banks.

In addition, as benchmark rates begin to rise, the effective return could increase further, discouraging the decline in business demand for the proposed capital expenditures.

As banks would be forced to raise lending rates, bringing them in line with the market-determined rate (with NBFCs following suit with a mark-up), the effects on the economy can be destabilizing.

The good thing is that we have also seen a substantial increase in new investment announcements which amounted to around 10 trillion rupees in the past two years, reaching an all-time high of around 19 trillion rupees in during fiscal year 22.


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