Indian Rate Hike Likely Due to Hike Likely Due To Fed-Dependent Monetary Policy

The RBI is likely to raise its benchmark rate by 25bps to 6% when it meets for the quarterly review of its monetary and credit policy on July 25th. With the US fed rate at 5.25% and the Fed likely to raise rates by at least another 25bps, the RBI has no option but to pre-empt the fed which meets on August 8th.

Otherwise, the already depressed rupee may be under even more pressure. Surely the country risk profiles cannot allow the differential to be lower than the current 50 bps. So, even though India does not have a high inflation risk (at least not demand side inflation), because it does not have the luxury of an independent monetary policy, it must raise.

As the RBI is dependent on the fed, the question is how high will the Fed go? Bernanke’s testimony to the Senate Banking Committee on Wednesday was guarded at best. He said the same thing that he has been saying all along – that fed action will be 'data dependent.' Markets rallied on hints in the testimony that the fed was ready to pause, of course there was no indication of when.

Two important statements make me (and half the world) think that 5.5% is a given – Bernanke said, “We must consider not only what appears to be the most likely outcome, but also the risks to that outlook and the costs that would be incurred should any of those risks be realized” Further – “Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take account of these risks in making its policy decisions”. Sounds ominous but all it means is – Data Dependent.

That said, bond futures indicate that fed rate of 5.5% is already being discounted. Indian bond yields in fact have rallied to 8.4% levels, factoring in higher than 6% domestic rates (higher than 5.5% for fed) already. So a bond rally is in the offing when markets open tonight. That means bank stocks will probably do well too. More on why banks should do well, later.

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