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The reasons for the 50 bps hike

The reasons for the 50 bps hike
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First Published: Tue, Jul 26 2011. 10 29 PM IST
Updated: Tue, Jul 26 2011. 10 29 PM IST
Why did the Reserve Bank of India (RBI) raise its policy rate by 50 basis points (bps) this time? The risks to growth from uncertainties abroad, which were made much of by the central bank in its mid-quarter policy statement in June, have increased instead of dissipating. The central bank also acknowledges that domestic growth has moderated somewhat in the first quarter of 2011-12, although it reiterates the slowdown is still not broad-based.
So what has changed? One, RBI says that inflation has been “even higher than expected”. But perhaps more important is its statement that the rate hike will “reinforce the point that in the absence of complementary policy responses on both demand and supply sides, stronger monetary policy actions are required”.
Simply put, it’s saying that if the government doesn’t do its job and reduce the fiscal deficit or build infrastructure and ease supply constraints, it has no option but to tighten the screws. And finally, of course, it may be worth remembering that if he doesn’t get an extension, this will be D. Subbarao’s last monetary policy statement. He might have decided to go out swinging.
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What is RBI’s message to the markets? Tuesday’s 1.87% fall in the Sensex said it all. In recent weeks, the market had been buoyed by hope that we would soon see a peak in inflation and that would mean nearing the end of the rate hike cycle. Well, RBI doesn’t seem to share any optimism about inflation. In fact, in spite of raising its policy rate by an unexpected 50 bps, it has upped its inflation estimate for end-March 2012 to 7%, a percentage point above its earlier estimate.
That seems at first glance a contradiction, for surely the purpose of the rate hikes is to reduce inflation? But maybe, as Gaurav Kapur, economist with the Royal Bank of Scotland Group Plc, points out, it is making the point that monetary policy alone cannot do much and the government needs to do its bit.
But has hiking rates by 50 bps now increased the chances of a pause in its mid-quarterly review in September? The one-year overnight indexed swap rate is pricing in just another 25 bps hike in a year.
Yet, RBI seems to be sanguine that commodity prices will remain high. It points out that oil prices have moved up again. It says that even if the global economy slows, “with no immediate prospects of monetary tightening in the advanced economies, the impact of weakening demand appears to be offset by that of abundant liquidity”. It also says that administered prices, such as those for coal and electricity, are likely to be revised upwards. And it states, “A change in stance will be motivated by signs of a sustainable downturn in inflation,” which the central bank itself doesn’t believe will happen by September.
But if there’s little solace on the inflation front, surely slowing growth could persuade RBI to pause? Trouble is, for that to happen, growth has to fall “significantly below trend”. So if RBI is to pause, the slowdown has to be much more than a mere “soft patch”. That’s hardly good news for the markets.
Graphic by Sandeep Bhatnagar/Mint
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First Published: Tue, Jul 26 2011. 10 29 PM IST