Indian Rupee's Reaction to Surprise RBI Interest Rate Hike Raises Eyebrows

- Rupee up after RBI rate decision pushed rates to 6.25%

- Domestic growth outlook and rising inflation cited as rationale

- Global growth a headwind due to increased protectionism

Image © Natanael Ginting, Adobe Stock

The Reserve Bank of India (RBI) decided to raise its base lending rate by 0.25% to 6.25% on Wednesday, June 06, as a result of a rise in inflation expectations and an improvement in the outlook for the economy, although it sees the rise of global trade protectionism as a headwind to sustained growth.

"On the basis of an assessment of the current and evolving macroeconomic situation at its meeting today, the Monetary Policy Committee (MPC) decided to increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points to 6.25 percent," the RBI says in its statement.

The rate hike will have come as a surprise to many analysts who only saw a small chance of a rise in June, although expectations had increased of a rise in August 2018.

"While we had anticipated that today's decision was likely to be a 'hawkish hold,' and had expected at least one more MPC member to vote for tightening today, compared to the 5 April meeting, when only one member dissented voting for +25bps, the early RBI move remains somewhat surprising," says a note from TD Securities in response to the move.

The RBI was particularly positive about domestic growth in its statement.

"The MPC notes that domestic economic activity has exhibited sustained revival in recent quarters and the output gap has almost closed. Investment activity, in particular, is recovering well and could receive a further boost from a swift resolution of distressed sectors of the economy under the Insolvency and Bankruptcy Code," says the Reserve bank.  

A fall in air and shipping freight activity reflected a decline in global growth, however, and posed a risk to the otherwise positive outlook.

"Geopolitical risks, global financial market volatility and the threat of trade protectionism pose headwinds to the domestic recovery."

In April, inflation surged to 4.58% from 4.28% in March, sparking heightened expectations of a rate hike.

The main causes of the inflation were increasing consumer spending and a rise in core components.

The recent rise in oil prices, however, have increased non-core inflation expectations, doubling up on the core increases.

"A major upside risk to the baseline inflation path in the April resolution has materialised, viz., 12 percent increase in the price of Indian crude basket, which was sharper, earlier than expected and seems to be durable," says the RBI.

Yet it is mainly the increase in domestic growth which prompted the rate hike.

"Turning to the growth outlook, the CSO’s provisional estimates have placed GDP growth for Q4:2017-18 at 7.7 percent – 70 basis points higher than that in Q3 – given the sharp acceleration in investment and construction activity. With improving capacity utilisation and credit offtake, investment activity is expected to remain robust even as there has been some tightening of financing conditions in recent months," says the RBI statement.

The impact on the Rupee was muted after the meeting, and USD/INR actually rose temporarily following the announcement which is a little surprising as the textbook suggests a currency should rise after a largely unexpected interest rate rise.

However, after a while, the exchange rate did then give back most of its gain and fell.

"The Rupee initially reacted with some unsurprising strengthening; which was then pared back completely and reversed; finally, INR started strengthening again. At the time of writing, INR is approximately 0.2% stronger to the USD vs pre-announcement levels," say TD Securities.

The same goes for GBP/INR which also rose after the RBI meeting ended, but then fell more in line with expectations and is currently trading at 89.83.

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