RBI should factor in a potential “Fiscal Cliff” event in the US in its policy review on the 31st of July 2012. Global bond markets are factoring in the worst for economic growth while domestic bond markets are testing RBI’s resolve in holding on to rates in the face of weakening growth expectations. The potential Fiscal Cliff could turn the tide in favor of rate cuts in July.
Ben Bernanke the US Federal Reserve Chairman pointed out the “Fiscal Cliff” that the US is facing in calendar year 2013 as a major threat to economic growth and labor markets. Ben forecast that if tax breaks ends and spending cuts begin, which is what the “Fiscal Cliff” is all about the US will enter into a minor recession in 2013. Ben urged the US government to take action to reduce the effect of “Fiscal Cliff” by framing a medium term fiscal consolidation plan. Ben however did not announce a third round of quantative easing to improve labor market sentiments and improve business and consumer confidence in the US.
US monetary policy is at record low with rates at close to zero percent and will be kept low till late 2014 as per the guidance given by the Fed. Fed has pledged that it will use all tools as appropriate to give a boost to labor markets and economic growth. If US policy makers fail to act to stem the potential effects of a “Fiscal Cliff”, the Fed will act by pumping in money to counter some of the withdrawal symptoms of higher taxes and lower spending.
RBI will have to watch out for the progress on the US economy in framing its own policy stance. If the US is likely to go into a mild recession in 2013, India will face its after effects. Revenues from IT service exports to merchandise trade will be hit, impacting the domestic economy. The Indian economy is in one of its worst phases with fourth quarter GDP growth at a nine year low of 5.3%.
RBI has started easing monetary policy over the last seven months with 125bps of CRR (Cash Reserve Ratio) cuts and 50bps of repo rate cuts. The central bank is going into its 31st July 2012 policy review on the back of IIP (Index of Industrial Production) trending down with May 2012 IIP growth at 2.4% against 6.2% seen in May 2011. India’s imports for June 2012 fell by over 13% year on year and close to 16% month on month. Lower imports to a certain extent reflect fall in oil prices (Brent crude has fallen by close to 20% from peaks over the last one year) but it also reflects a weakening economy as substantiated by weak GDP growth and weak IIP growth numbers
Inflation is proving to be a dampener for the RBI as well as the market, which is expecting monetary easing by the RBI. Inflation as measured by the WPI (Wholesale Price Index) for June 2012 came in at 7.25%, below 7.55% levels seen in May 2012. Inflation is expected to stay sticky at around 7.5% levels due to rising food prices.
Monsoons have disappointed this year with rainfall at 22% below average as of July 2012. Weak monsoons can take up food prices but bring down GDP growth and RBI has to strike a fine balance between inflation driven by lack of adequate food supply and inflation driven by demand, which can weaken due to poor monsoons
Bond markets have started factoring in weak economic growth with swap yields at ten month lows and bond yields at over one year lows. Five year OIS (Overnight Index Swap) yields are trading at below 7% levels down 60bps over the last four months while ten year bond yields are trading at below 8.1% levels, down 40bps over the last four months
Globally bond markets are factoring in steep falls in GDP growth and are expecting central banks to keep interest rates at record lows for extended periods of time. Ten year bond yields from the US to Germany to Japan are trading at or close to all time lows. A Fiscal Cliff event in the US will further take down global bond yields.