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Emkay Global Financial Services has released a note post the latest meeting of the US Fed.

RBI: between Devil and Deep Sea

RBI now has little option but to let the rupee slide gently - Rupee is down 9.6% YTD even as DXY has appreciated nearly 20% - probably the fastest rise on record. RBI has expended about $80bn -about 15% of reserves - moderating the rupee fall and that was the apt policy choice then. As RBI was selling down dollars - the excess liquidity (as reported at LAF window) normalized from a Rs.8 trillion surplus to a Rs.1 trillion deficit presently. This was in sync with its policy normalization move as well. Emkay economist estimates Central Govt’s balances with RBI at about Rs.3.6 trillion which will eventually ease the deficit. However, given growth dynamics (real GDP growth still below trend growth unlike developed economies) and the RBI's own policy stance, LAF's ideal liquidity should be around Rs.2-.25 trillion or about 1% of NDTL

RBI's policy choices now will be more limited - any significant dollar sales will tighten liquidity (and interest rates) and start choking growth. Of-course, RBI can supplement the liquidity by doing OMO (buying bonds) to replenish liquidity - this though can send confusing signals to market as policy rates are still being tightened. The line of least resistance is now for rupee to decline and RBI will prefer flexibility over interest rates as against exchange rate. Of-course RBI could get a helping hand if DXY stabilizes or crude corrects further. That brings us to DXY

DXY: peak hawkishness is a better guide then pending rate increases

DXY: has it topped with peak hawkishness? A 20% rise in DXY is a ferocious move and such sharp moves in exchange rates (particularly for developed economies) are rare and usually self-limiting. Emkay economist’s report accurately estimated further strength in DXY since May (our current target is 116), though we turned bearish on DXY shortly after Powell's Jackson speech. We still believe post recent FED dot plots (4.6% terminal rate through early 2023) - the threshold level for inflation print to relatively disappoint (versus other economies) is very, very high. We believe that FED's commentary is mostly aimed at keeping financial conditions tight - which therefore super emphasizes controlling inflation even at the expense of growth. FED has thus guided the markets to stop reacting to any softer economic numbers.

So while DXY will need very bad inflation prints to move higher, a meaningful pull back is unlikely till inflation prints (or proxies) come in below expectations. It seems very likely as per our understanding. Euro’s CA deficit is primarily driven by huge forward purchases of energy to secure for winter. That too is mostly done with 84% storage fill. Economy: the unknown unknown

Neither we nor FED knows how the economy will respond to such a sharp and a quick reset in policy rates. We do know that aggregate demand needs to be sacrificed to re-balance it in sync with aggregate supply. If the supply curve is steep, a lower sacrifice ratio will be enough to kill inflation. We can't be simply guided by 1980's as inflation expectations then were completely unanchored (running at 12% plus) and that necessitated sharply higher rates for longer.

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