Can Indian and Indonesia policy rates get slashed?

In line with USD rates observations.

If short term USD rates are to rise to circa 2% by end-2016 it has been noted that Singapore, Philippine and Thai short term rates, then, are probably going up over the next 18 months.

According to a research note from UBS, in its view, one reason interest rates were able to fall so far in those countries – without unwanted currency weakness – was the low level of US rates.

The report doesn't think Bank Negara Malaysia policy rates will rise but there is probably not much downside for BNM policy rates without risking ringgit weakness.

However, it thinks the debate is less clear for India and Indonesia. Policy interest rates where previously increased in both economies while US interest rates remained low – in part due to sharp currency weakness, current account deficits and higher inflation.

Here's more from UBS:

Now, we think, activity growth is below potential and the credit cycle depressed in both India and Indonesia. That suggests disinflationary pressures.

Below potential growth should also help reduce current account deficits. In India, lower oil prices could push the external balance towards surplus in FY 2015-16.

The upshot is that if our trend disinflation projection plays out in India, the inflation gap between the US and India will narrow. The Figure below shows the implied inflation and interest rate gaps if there is no change in Indian short term interest rates.

The elevated gap between the interest differential and inflation differential (the grey shaded area) supports the notion that Indian interest rates have room to fall. Of course it is possible that our forecast decline in Indian inflation (5% in 2016 vs 5.8% consensus) is too optimistic.

Specifically the monsoon could be worse than we expect or oil prices higher Likewise the rise in US inflation we project could be too bearish (2.4% vs. 2.2% consensus).

For Indonesia, the same analysis suggests a less strong case for lower interest rates. Additionally, Indonesia's current account deficit probably needs to narrow sustainably towards 2% of GDP before policy rates can be reduced further.

As such, even though we believe Indonesia's authorities are under pressure to support growth, we expect the central bank to wait until after the initial market adjustment to higher Fed rates is past before lowering policy rates a further 50bps in late 2015.

In the meantime BI will likely continue to ease macro prudential measures to support credit expansion. An earlier policy rate cut could add to unwanted liquidity related pressure for currency weakness.