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Business News/ Opinion / Online-views/  RBI had no option but to go for a larger rate hike
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RBI had no option but to go for a larger rate hike

RBI had no option but to go for a larger rate hike

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The central bank hiked its key repo rate by 50 basis points (bps) in line with our expectation, but surprising the bond market, which had bet on a 25 bps hike. One basis point is one-hundredth of a percentage point.

Along with the rate hike, the Reserve Bank of India (RBI) also implemented changes to monetary policy operating procedures by placing the repo rate as the single policy rate in the middle of a 200 bps corridor within which it will strive to maintain the overnight rate. In a nod to savers, RBI also hiked the savings bank rate by 50 bps, pending a decision on deregulation of the same.

Some of the criticism was unfair given that the central bank was not in a position to do much about inflation originating from food prices. Indeed, RBI is also handicapped by the lack of a proper measure of core inflation in India.

Conceptually, a measure of core inflation should capture the underlying sticky price movements, assuming that inflation expectations are influenced by such sticky prices. The measure used by RBI, non-food manufacturing Wholesale Price Index (WPI), is heavily weighted towards commodities and intermediate goods and does not capture sticky price movements. Rather, it provides a good snapshot of the input price pressures faced by firms.

In a situation of the economy operating at potential, such price pressures can easily translate to consumer prices and can get embedded in inflation expectations in the absence of counter-cyclical policy response. Thus, non-food manufacturing WPI inflation serves as an indicator of pipeline inflation pressures.

Over the last few months, this indicator has been flashing alarm signals; inflation on this head touched 7% in March and is likely to average just above 7% in FY12, implying that headline WPI and inflation expectations may continue to remain above RBI’s comfort zone.

Indeed, RBI’s March 2012 inflation estimate and the intra-year trajectory are broadly in line with our expectations. The central bank has also opted to take commodity prices on an as-is-where-is basis rather than make any aggressive assumptions about moderation in prices.

The inevitable conclusion for RBI must have been that policy rates have to move up further and sooner to prevent inflation expectations from worsening, leading to the 50 bps hike. With this action, RBI has bought itself breathing space for the next couple of months. Any upside surprise on near-term inflation and a likely fuel price hike should not cause undue alarm in financial markets.

While we judge that the repurchase rate will need to go up by a further 50 bps, the timing of the next rate hike is not cast in stone. The base case scenario is for RBI to opt for two more doses of 25 bps hike in June and July.

In any case, we see RBI hiking the repo rate to 7.75% by September and then pausing.

A. Prasanna is chief economist at ICICI Securities Primary Dealership Ltd.

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Published: 03 May 2011, 01:15 AM IST
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