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RBI Raises Key Policy Rates To Stamp On Inflation

27 July, 2010

The Reserve Bank of India has affected a hike in its two key policy rates (repo and reverse repo rate) by 25 bps and 50 bps respectively earlier today as part of its First Quarter Monetary Policy Review. The repo (rate at which banks borrow from the RBI) and reverse repo rate (rate at which banks earn interest for sums parked with the RBI) now stand at 5.75% and 4.50% respectively.

According to Ritika Mankar, Economist, Execution- Noble, high positive inflation (north of 10% for 5 consecutive months) coupled with strong growth momentum provided the RBI with the basis and the confidence for raising policy rates in a calibrated manner – the third monetary policy move in FY11.  

Mankar added that the increase in the reverse repo rate by 50 bps was ahead of their expectations. The rationale of this move was to crop the rate corridor (the difference between the repo and reverse repo rate) from 150 bps to 125 bps in a bid to restrict the short term interest rate volatility as call rates fluctuate within this corridor.

The other rationale behind this move is to maintain a tight monetary policy stance even when the liquidity scenario changes and the reverse repo rate becomes the relevant policy rate. (In a tight liquidity situation such as today when banks borrow money from the RBI at the repo window, the repo rate becomes the relevant policy rate. On the other hand in an excess liquidity situation the reverse-repo rate is the relevant policy rate.)

The research firm expects  the monetary tightening to continue and that they “expect a 25 bps hike in all three policy rates (CRR increase conditional upon the liquidity situation improving) at the mid-quarter review (henceforth the RBI will undertake mid-quarter monetary policy reviews besides its regular quarterly reviews) in mid-September in tune with its broader strategy of calibrated monetary policy normalization and checking inflation without hurting growth.”

REUTERS ADDS

One-year overnight interest rate swap rates jumped after the Reserve Bank of India (RBI) notched up its fourth rate rise this year and said it was “imperative” to normalise policy in line with the economy’s growth and inflation.

Before Tuesday, the RBI had promised a “calibrated” exit from the loose monetary policy adopted during the global downturn, which markets had taken to mean 25 basis point rate hikes on Tuesday and again at quarterly reviews set for October and January.

“The dominant concern that has shaped the monetary policy stance in this review is high inflation,” the RBI said.

“With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations,” it said.

Bond yields and swap rates rose in reaction to the RBI’s decision. The 10-year benchmark bond yield gained 3 basis points to 7.70 percent.

The most-traded 1-year overnight indexed swap rate jumped 19 basis points to 6.1 percent, its highest since November 2008.

The RBI lifted the repo rate, at which it lends to banks, by 25 basis points to 5.75 percent, which was in line with expectations.

But its bumped up the reverse repo rate, used to absorb excess cash from the system, by 50 basis points to 4.50 percent. A 25 basis point rise had been expected.

Analysts said the moves showed the RBI was trying to take more decisive action following criticism that it had acted too timidly so far to tackle rising prices that the authority acknowledged had spread beyond food to the broader economy.

“Of course, they are behind the curve on inflation,” said Dariusz Kowalczyk, senior economist and strategist at Credit Agricole CIB in Hong Kong.

“They are trying to catch the train that has left the station and they are running to accomplish that. Unfortunately, they were late to the races and this means they would have to tighten more than they would have if had they started earlier,” he said.

INFLATION

Reflecting the RBI’s inflation concerns, it lifted its inflation forecast for 2010/11 fiscal year ending March 31, to 6 percent from a previous forecast of 5.5 percent.

It said inflationary pressures had become generalised and demand side pressures were clearly evident as an economic recovery was firmly in place. It forecast GDP would rise 8.5 percent for the year through March 2011.

Wholesale inflation, the most closely watched measure of price pressures in India, rose 10.55 percent in June from a year earlier.

A government move to free up gasoline prices and raise other fuel prices will push inflation up to about 11 percent in July, the government’s chief statistician said, marking double-digit inflation for the sixth month in a row.

High prices have become increasingly problematic for a Congress party-led government whose core constituency is predominantly poor and rural. Over 40 percent of India’s 1.2 billion people live in abject poverty.

Its announcement on June 25 to increase fuel prices prompted the opposition to call a one-day nationwide strike this month. Protests over rising food prices briefly shut down India’s parliament on Tuesday, signalling the potential for delay in passing reforms bills.

Opposition members raised slogans in parliament’s lower house after the government turned down their demand for a debate and a vote on rising prices. [ID:nSGE66P09U]

“The clearly strong and generalised nature of inflationary pressures, coupled with improving growth conditions, have forced the RBI to act with more urgency,” said Gaurav Kapur, senior economist at Royal Bank of Scotland in Mumbai, who expects a further 50 to 75 basis points of tightening this fiscal year.

The RBI said current tightness in liquidity in the banking system means its policies would have greater impact on the economy.

It also promised greater transparency in its decision making, saying in the future it would hold additional policy reviews between its regular quarterly meetings.

Two of the RBI’s four rate rises this year have occurred outside of authority’s scheduled meetings.

As expected, the RBI left the cash reserve ratio (CRR) unchanged at 6 percent.


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RBI Raises Key Policy Rates To Stamp On Inflation

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