Inflation surges to 8-year high! Here’s what it means for the economy, stocks and bonds

NEW DELHI: For anyone wondering why the Reserve Bank of India showed the degree of urgency it did when it hiked interest rates in an off-scheduled move last week, the latest data on inflation provides a clear-cut answer.

India’s headline retail inflation skyrocketed to an 8-year high of 7.79 per cent in April, data released by the National Statistics Office yesterday showed.

While announcing the rate hike after an unscheduled meeting of the Monetary Policy Committee last week, RBI Governor Shaktikanta Das had warned that the April inflation print would be elevated but the degree to which the consumer price gauge rose last month has exceeded expectations.

A Reuters poll had estimated Consumer Price Index inflation at an 18-month high of 7.50 per cent in the previous month.

As it stands, it is now pretty much a given that the RBI will follow up last week’s rate action with a fresh rate hike in June. The question, however, is by how much?

Das had said last week that the process of reversing the accommodation extended during the early stages of the COVID-19 crisis had started with the 40-basis-point hike on May 4, which took the repo rate to 4.40 per cent.

Given that the repo rate was lowered from 5.15 per cent to a record low of 4 per cent in 2020, it would require interest rates to be raised by 75 basis points more to reverse the pandemic-era rate cuts.

But, given the magnitude of the surge in inflation and with hardening global commodity prices keeping upside risks to inflation elevated, markets are abuzz with speculation that the central bank may have to raise rates by much more than 75 bps going ahead.

BNP Paribas said in a note last week that it expects the repo rate to be raised by 60 bps in June, followed by 50 bps each in August and October and 25 bps in each meeting thereafter till June 2023, taking the repo rate finally to 7 per cent.

While that prediction is one of the more aggressive ones, analysts are more or less united that the repo rate will climb by close to 100 bps from current levels.

What does it mean for the economy?
Finance Secretary TV Somanathan told CNBC TV18 that India’s economic growth rate is likely to slow if the central bank hikes interest rates.

It is worth noting that the statement from the Finance Ministry comes at a time when the RBI is just beginning the process of rate hikes.

While Das himself last week acknowledged that rate hikes would have an impact on output, the central bank head also said that a de-anchoring of inflation expectations would affect economic growth detrimentally.

There is no doubt that the erosion of purchasing power has started to exert a toll on economic growth as individuals realign spending patterns amid price hikes in a wide range of consumer items.

Higher interest rates and therefore tighter financial conditions are seen having an impact on aggregate demand in the economy but the central bank may have little option but to tackle the inflation bull by the horns.

On Wednesday, Morgan Stanley reduced its forecasts for India’s GDP growth to 7.6 per cent from 7.9 per cent for the current financial year and to 6.7 per cent from 7 per cent for the next fiscal year.

“The key channels of impact will likely be higher inflation, weaker consumer demand, tighter financial conditions, the adverse impact on business sentiment, and a delay in capex recovery,” the global firm said.

This comes on the back of recent reductions in India’s growth forecasts by several other organisations including the International Monetary Fund, the United Nations Conference on Trade and Development and overseas bank UBS.

How would stocks react?
The prospect of fresh sharp increases in interest rates and further steps to remove surplus liquidity from the banking system does not bode well for domestic equity markets, which have since last week reeling under the impact of an unequivocal hawkish turn by central banks home and abroad.

The RBI is almost certain to accompany rate hikes with more increases in Cash Reserve Ratio maintenance for banks, which would suck out excess funds from the banking system.

The huge pandemic-era liquidity infusions by the RBI amid a regime of record-low interest rates were a key factor that sent India’s stock markets soaring to all-time highs in 2021.

With markets now faced with the dreaded combination of rate hikes and slowing growth, analysts have questioned the valuations of Indian equities while FIIs continue to dump domestic stocks at an unprecedented level amid sharp rate hikes in the US.

The Nifty and the Sensex both dropped around 4 per cent since last week and technical indicators suggest more pain in the offing.

The recent surge in government bond yields goes to make matters worse by posing a clear-cut threat to equity valuations, analysts said.

“The general rule of thumb is that higher the risk-free rate of return (government bond yields), the higher is the discount rate that gets modelled into the DCF – the discounted cash flow model based on which the fair value of any share is determined,” independent market analyst Ajay Bodke said earlier this week.

The market analyst warned that leveraged companies and those with large cash flows that are distant could be disproportionately impacted.

Consequently, so-called growth stocks, whose valuations factor in cash flows that are well into the future, could take a hit.

No respite for bonds
The government bond market, which represents borrowing costs across the economy, has witnessed a bloodbath of late as the RBI’s urgency to catch up to the inflation curve has caught the market by surprise.

Yield on the 10-year benchmark government bond has surged by 79 basis points so far in 2022 and analysts expect much more of a rise. Bond prices and yields move inversely.

While news reports quoting sources have said that the government was displeased with the recent surge in gilt yields, the fact remains that the RBI has very little room to manage bond yields the way it has for the last couple of years.

With the government announcing a massive, all-time high gross borrowing programme for the current year, bond traders have lamented a sharp mismatch in demand and supply for sovereign paper.

At a time when it is raising interest rates and actively draining out surplus liquidity, the RBI cannot step in as a major buyer of bonds and keep a lid on yields as such acquisitions by the central bank lead to addition of durable liquidity in the banking system.

“We are expecting the 10-year yield at around 7.40% by the end of the month, the trajectory of yields will be upward,” ICICI Securities Primary Dealership’s Head of Trading Naveen Singh told ETMarkets.

“Through the off-policy rate cut, the RBI has signalled its intention to act swiftly on inflation so my view is that there will be a 50 bps rate hike in June. 75 bps could be overkill and 25 bps would be a wasted bullet, so 50 bps is the expectation.”

The clear takeaway is a rise in borrowing costs across the economy – from companies tapping the bond market to individuals whose loan pricing is linked to sovereign debt products.