India’s inflation trajectory has been stable leading to compressed differentials with the US: this led to a lower rate hike cycle and a possible longer-term lower yields
Reserve Bank of India’s (RBI’s) pause in its recent policy announcement has now been commented upon by many: it has been noted clearly that it is a pause, not a pivot. We look beyond the immediate pause/pivot to understand why the US has had to raise rates by 450 bps (and possibly some more to go) while India has been able to pause after a hike of only 250 bps.
Inflation and interest rates
For India, a capital importing country with bouts of inflation, a higher yield in INR has traditionally been required to attract (and retain) foreign capital. This higher yield compensates investors for the expected inflation in India which corrodes the buying power of the INR. The higher inflation, for the foreign investor, shows up in the depreciated exchange rate of the INR vis-à-vis the USD. The yield difference between INR and USD is hence a compensation for inflation for domestic investors and currency depreciation for foreign investors.
In 2022, major economies faced surging inflation led by cost-push and pent-up demand pressures. Russia-Ukraine conflict, which started in end-February 2022 further increased such pressures with its impact on commodity prices and supply chains. In their responses, central banks of major economies undertook monetary tightening to quell inflation.
The US Federal Reserve began hiking interest rates in March 2022 and by March this year, it had hiked rates cumulatively by 450 bps to a range of 4.75 to 5.00%. Over the same time frame, RBI raised the repo rate by a total of 250 bps to 6.50%. Consensus estimates suggest that US Fed may tighten another 25 bps; RBI recent pause may eventually turn into a pivot.
India’s rate hiking trajectory is hence materially less pronounced than US. Under usual circumstances given the logic of attracting and retaining foreign capital, expected tightening in India would ideally have matched that of the US or even gone a notch higher.
INR, USD yields are converging…
The spread between Indian and US 10-year government yields contracted sharply as US yields have risen faster than their Indian counterpart. Indian 10-year yield has stabilized around 7.30% over the last few months; falling to 7.20% post the pause. The spread of only around 380 bps between the 10-year yields of these countries is a decadal low.
If we analyse the difference in 10-year government yields between India and the US over the past twelve years, we see two distinct phases. Over the first six-year period of CY2011-16, the spread averaged 589 bps. With India adopting flexible inflation targeting (FIT) in 2016, the average spread over the next six years, i.e., CY2017-22, fell by 121 bps to 468 bps. In context of these numbers, the current around 380 bps spread is a material departure from long-term trends.
….led by diverging inflation experiences
The spread in yields is driven by the inflation differential between the two countries. We note that the first period (CY2011-16) was characterized by high inflation in India and in the latter period (CY2017-22), for the most part, RBI was able to maintain inflation within its target range of 4% +/-2%. The inflation band is a product of the 2016 agreement of the RBI with the government of India to maintain inflation within this range.
RBI’s inflation fighting credentials are currently reasonably strong. Indian CPI peaked at 7.8% in April 2022 and has come down to 6.4% in February 2023. While Indian inflation was above 6% for many months, the breach was not as sharp or as consistent as it has been in the US: the US inflation has veered far away from their 2% average target.
As we note in the accompanying chart, inflation differential between the two countries has narrowed: CY2011-16 inflation differential between India and US was 580 bps; it fell to 150 bps in the period CY2017-22. Over CY2022, the average differential was negative 130 bps, an occurrence last seen briefly in CY2005. In the last two decades of this century, the recent negative spread has been the longest stretch.
The reasons for inflation in both the economies are reasonably similar in some respects (food and fuel) and different in some (labor tightness in the USA leading to higher wage growth which shows up in the services inflation). The aggressive interest rate hikes by the Fed may cool down the economy enough to lower wage growth.
What if this is the new normal?
With the means of inflation and yields in both economies having materially changed over the last decade, it is important to pause and reflect on what the mean, going forward, can be. If the inflation differential continues to sustain at a lower level, Indian yields may be headed towards relative moderation.
This has implications for INR cost of capital, in general, and cap-rates (for REITs and InvITs) in particular, which can trend downwards. A low inflation differential can also show up in a reduced depreciation bias for the INR.
RBI’s ability and credibility in keeping inflation in 4%+/-2% range coupled with the US Fed’s willingness to live with moderate inflation will determine this trajectory.
With research support from Akshata Kalloor.
The author is with National Investment and Infrastructure Fund Limited. Views are personal.
Akhilesh Tilotia 