Rupee Slips after Inflation Surprises on Downside, Bank of America says Weakness is Here to Stay

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- Inflation rises less than expected in September as core-CPI falls.

- Data lessens pressure on RBI for rate hikes, leading the INR lower.

- Bank of America says there are more INR losses just around corner.

The Rupee pared gains Friday after inflation surprised on the downside for September, at the same time as Bank of America analysts warn of a protracted period of weakness for the Indian currency. 

Indian consumer prices rose at an annualised pace of 3.77% in September, up only a fraction from the 3.69% seen in August, when economists had anticipated an increase to 4%.  

Prices of food items, which comprise almost half of the consumer price basket, have risen slower than many had expected during recent months and spared the consumer price index from the kind of increase economists had projected.

Core inflation, which removes volatile food and energy items from the goods basket, was estimated to have declined from 6% to 5.8% during the recent month. 

The core inflation rate is seen by many, including central banks, as representative of domestically generated inflation pressures so garners most of the market's attention. 

"This was a little weaker than we and the consensus had expected. It still leaves headline inflation a touch below the Reserve Bank’s long-term target and arguably provides some vindication for the Bank’s decision not to raise rates again last week," says Shilan Shah, an economist at Capital Economics. 

The USD/INR rate was quoted 0.31% lower at 73.64 during the London noon after having risen from 73.55 in response to the announcement.

The Pound-to-Rupee rate was 0.98% lower at 96.75 although it has fallen persistently throughout the session, in line with other Sterling exchange rates.

September's decline in the core rate gives the impression that Indian inflation pressures are in decline after being exggerated by pundits.

This likely explains the Rupee's retreat on Friday as such a scenario would lessen the case for the Reserve Bank of India (RBI) to raise interest rates again this year. 

However, Shah has warned that food prices will soon pickup. He also says the 2018 currency depreciation and increase in oil prices will soon be further reflected in the figures. 

"The monthly CPI data typically track the weekly data well. Accordingly, a further pick-up in food inflation this month seems likely," he writes, in a note to clients. "If the economy maintains its current momentum, capacity utilisation will tighten further, further boosting underlying pressures. Higher inflation expectations and looser fiscal policy will also tend to prevent core inflation dropping back."

2018's 20% increase in oil prices, as well as a double-digit depreciation of the Rupee that has made imported goods more expensive to buy, have already prompted the Reserve Bank of India to raise its interest rate by 50 basis points to 6.5% this year.  

Changes in rates are only normally made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators. 

The RBI is required to keep inflation at 4%, plus or minus 2% in either direction, over the medium term. This, alongside the a still-above target core inflation rate could mean that it is only a matter of time before the central bank moves again.

"The RBI doesn’t have to tighten aggressively – one advantage of having started to hike fairly quickly as core inflation rose this year is that it doesn’t have a huge amount of catching up to do. But it also can’t consider its job done while core inflation remains so high. We are forecasting one more 25bp increase in the repo rate in this cycle," says Shah. 

The USD/INR rate has risen 15.4% in 2018, denoting a stronger U.S. Dollar and weaker Indian Rupee. The Pound-to-Dollar rate has gained 12.4%, despite Sterling also having declined against the Dollar, providing insight into the extent to which weakness in the Rupee has driven the move in the USD/INR rate. 

Strategists at Bank of America Merrill Lynch said Friday that further losses are likely looming along the road ahead for the Indian currency.

"We believe risks are skewed towards further INR depreciation and the market does not seem to be prepared for this," says Rohit Garg, a director of currency and bond research at Bank of America. "80 may not be the “right” level for USD/INR but a break above 75 could lead a position driven squeeze higher in spot and volatility." 

Garg and the Bank of America team cite an anticipated additional increase in oil prices and another expected rise in U.S. interest rates as being behind their view. 

Rising oil prices have lifted inflation and the level of imports this year, which can reduce GDP growth in the first order and hit economic growth again by placing additional demands on household incomes. 

It has also got investors fearing a protracted deterioration of the current account balance, which measures changes in the amount of money flowing into and out of the country as well as movements in borrowing from the rest of the world.

Markets care about the data because it paints a telling picture of international demand for a currency while also providing insight into the extent to which a nation is exposed to changes in the sentiments of international lenders toward it.

The Federal Reserve has raised interest rates eight times since the end of 2015, including three times in 2018, taking the Fed Funds rate range to between 2% and 2.25%.

This has sucked capital out of the more risky investment destination that is the emering market world and pressured the currencies of developing nations in turn. 

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