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Does a cold winter await the Indian rupee?

The Indian rupee (INR) has been range-bound for a few years now. After all, it crossed 73 rupees to a dollar almost three years ago and has been oscillating between that and 75.5 for the most part of this time.

Historically, the rupee has either drifted down every year against the dollar (USD) or when it remains range-bound for a few years, the move can be very quick and precipitous. Is it headed that way once again? Let's look at a few factors, including inflation and the trend in yields around the world.

The point to remember is that in macroeconomic variables, when you try too hard to hold on to one, something pops out from the other end. In this case, the Reserve Bank of India (RBI)'s valiant efforts to hold on to interest rates will likely result in pressure being put on the currency.

In India, the Wholesale Price Inflation (WPI), a proxy figure for producer prices, rose to 14.2 per cent yoy, its highest level since December 1991. The high rate of inflation in November 2021 was primarily on account of a jump in prices of basic metals, crude petroleum & natural gas, chemical and chemical products, and food products. The base effects could not be blamed, as the month-on-month number too came in at 2.73 per cent, the highest in a decade.

Meanwhile, Consumer Price Inflation (CPI) is already perking up and was last seen at 4.91 per cent yoy despite excise duty cuts on fuel by the Centre and the subsequent cut in levies by states. Although, there is a compositional difference between the WPI and CPI indices, a 2013 paper that modeled the relationship between these two indices concluded that WPI is determined by market forces and is usually also a leading indicator of consumers’ prices and inflation.

Thus, it is safe to say that these lofty WPI numbers are sure to act as a tailwind for CPI and a headwind for RBI’s easy monetary policy, which has been skewed towards supporting growth at the risk of excessive inflation. A direct impact of the policy response in the face of rampant price pressures is visible in the household inflation expectations, which continue to rise.

According to data from the RBI’s survey, the median inflation expectation of households rose by 20 bps to 10.4 per cent yoy in November. However, the three-month and one-year ahead median inflation expectations saw a sharper increase of 150 bps to 12.3 per cent yoy and 170 bps to 12.6 per cent yoy, respectively, the highest since September 2014.

Also, crucially, even as the RBI has stuck to its accommodative monetary stance and not hiked rates, there have been a barrage of aggressive rate hikes across most other emerging markets — such as Brazil, Colombia, Mexico, the Czech Republic, Poland, Russia, Hungary, and even South Korea — since the middle of the year. India is becoming an outlier in this cycle and it is entirely possible, or even likely, that the rupee may act as a release valve.

A historical analysis of the USD-INR pair indicates that the rupee is prone to sharp losses after medium to long periods of slumber (see the chart given below). After such an interval of relative calm, all that is required to push the currency over the ledge is a trigger.

One of the potential triggers this time around could be the commencement of rate hikes by developed markets — the market is already priced for at least two rate hikes by the US Federal Reserve in 2022 — just as ex-Asia emerging markets pass the peak aggressiveness of their rate hike cycle. Thus, say the US Federal Reserve does hike rates, it could push the INR-USD over the edge. However, the currency may not even wait that long for the actual hike to happen, given the Fed has already indicated that it was more likely than not to change its ultra accommodative stance.

In short, whether it is from the inflation angle or yield cycles in other economies or simply the fact that the INR-USD pair has been range-bound for long, the downside risk for the rupee appears high.

US Dollar - Indian Rupee (USD-INR) Exchange Rate

(A version of this article first appeared in The Economic Times)

From the desk of Devina Mehra

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