RBI could keep rates higher for longer amid global and local risks

Mumbai: Overseas developments could play a greater role in the Reserve Bank of India's monetary policy decisions as financial risks become more cross-border and interconnected, economists said.

Speaking to ET, economists said governor Sanjay Malhotra's speech at the Fifth Kautilya Economic Conclave, three days before the monetary policy decision, was a hawkish signal indicating that rates may remain higher for longer as global and domestic risks converge.

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"In a way, the governor's speech is preparing the market for a higher-for-longer interest-rate environment than previously anticipated. The key driver of the RBI's policy reaction function is likely to be the steady tightening in global financial conditions," said Madhavi Arora, chief economist at Emkay Global Financial Services.

Arora said countries with a current account deficit such as India are facing challenges because higher US rates mean a significantly higher risk premium needs to be offered, particularly as global volatility and oil prices drive financial conditions.

Indeed, the gap between the 10-year benchmark Indian yield and the 10-year US treasury yield has narrowed to 193 basis points from a recent peak of 273 basis points in March as the US bond yield has risen to a 24-year high.

In his speech on Saturday, Malhotra listed elevated global debt, stretched asset valuations linked to AI, higher leverage, defaults in private credit and cyber risks compounded by AI as emerging risks to global financial stability.

"The challenge before us is to build a financial system that can withstand the shocks we anticipate and those we cannot yet foresee. This requires resilient institutions, better data, deeper markets, credible safety nets, effective resolution mechanisms and regulation and supervision that are proactive and forward-looking, while being proportionate," Malhotra said.

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Economists said Malhotra's comments so close to the policy decision had put any doubts over a rate hike on Wednesday firmly to rest. With most of the risks stemming from overseas, global factors have also come to the forefront.

"Overseas factors are now more challenging with oil prices higher, US treasury yields up and generally market a little uncertain. On the domestic side, household debt is higher, credit growth is above the 10-year average and rupee remains under pressure. All these risks will play out into higher rates now with at least 50 to 75 basis point hikes priced in this cycle," said Indranil Pan, chief economist at Yes Bank.

Higher crude oil prices and lacklustre dollar inflows mean global financial conditions could increasingly dictate the course of domestic monetary policy, rather than domestic growth and inflation dynamics alone.

Brent crude has risen above $100 a barrel this month on renewed US-Iran tensions after falling closer to $70 a barrel in July.

"In the US, there is already a balance sheet expansion, a rate hike cycle and political pressure not to hike rates are playing out. These factors are all incongruous to each other and hence markets are manifesting in higher bond yields across developed markets, that are destined to go even higher," said Soumya Kanti Ghosh, group chief economic advisor, SBI.

“Together with these global factors, in India, in the second half of the fiscal, we will see higher inflation on the back of a weaker monsoon. With the dollar index set to strengthen further from current levels and capital outflows ($4.5 billion in the last week already) with higher US yields, the rupee will be under pressure,” said Ghosh of SBI.

From the RBI’s perspective, Governor Malhotra would want to communicate the central bank’s forward path more clearly. The speech on Saturday prepares the ground for a shift to more hawkish language.

“The last MPC minutes conveyed a distinctly different message from the actual policy action and came across as relatively hawkish. This time, the emphasis needs to be on consistent communication and preparing markets for what lies ahead,” Arora from Emkay said, adding that there remains an outside chance that the RBI may deliver a 50-basis-point hike on Wednesday rather than the widely expected 25 basis points, as a form of policy catch-up.