RBI tightens monetary policy more than expected

RBI tightens monetary policy more than expected

Mumbai: Concerned about ‘high inflation’, the Reserve Bank of India (RBI) on Tuesday hiked its key policy rates by 0.25% and 0.50% respectively even as it said that inflation, by the end of the fiscal, will be more than what it expected earlier.

RBI hiked the repo rate, or the rate at which it injects liquidity in the system, by 0.25% to 5.75% and reverse repo rate, or the rate at which it drains liquidity from the system, by 0.50% to 4.50% with immediate effect. All other rates remained unchanged. The deposit, credit and money supply growth projections also remained unchanged.

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The bond market was a bit surprised by this move. The yield on the 10-year paper rose to 7.70% from 7.67% just before the policy announcement at 11.30 am.

According to bond dealers, the market was expecting a 0.25% rise in both policy rates.

“The tone is more hawkish, with this policy statement, the downside pace of yields will slow down," said S. Raghavan, head of treasury at IDBI Gilts Ltd.

Raghavan expects 10-year bond yield to remain within the range of 7.62-7.72% this week.

The stance of the policy, according to RBI, is intended to contain inflation and anchor inflationary expectations, maintain an interest rate regime consistent with price, output and financial stability and actively manage liquidity to ensure that it remains broadly in balance so that excess liquidity does not dilute the effectiveness of policy rate actions, according to the policy remark by RBI governor D. Subbarao.

Subbarao justified the narrowing of the policy rate corridor by saying while there is no unique way to determine the appropriate width of the policy interest rate corridor, but it should be broad enough not to unduly incentivise market participants to place their surplus funds with the central bank or it should not be so broad that it gives scope for greater interest rate volatility to distort the policy signal.

“The challenge, therefore, is to strike the right balance."

Indian banks that used to park more than Rs1 trilion of the surplus fund with the central bank in January, now borrows a daily average of more than Rs40,000 crore from RBI due to a liquidity crunch caused by advanced tax outflow and payments towards telecommunication licenses.

“The success of the policy depends on how banks responds to sector specific rate adjustments," said Rupa Rege Nitsure, chief economist at public sector lender Bank of Baroda.

“I expect lending rates to go up but banks should make sure they adjust the spread in such a way that cost of borrowing rises in sectors that are showing some signs of overheating at the same time, genuine credit needy sectors like SMEs, labour-intensive, export-oriented sector continue to get cheap credit," said Nitsure.

Bankers were not available for comments by the time of filing this story.

In the first quarter policy statement, the RBI governor said the economy is expected to grow at 8.5% in 2010-11 against the previous expectation of 8% and said he expected headline inflation to rise to 6% from 5.5% for the same period.

“The dominant concern that has shaped the monetary policy stance in this review is high inflation," Subbarao said in his first quarter policy statement.

“… with growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations," he said.

“Inflationary pressures have exacerbated and become generalized, with demand-side pressures clearly evident.

“Inflationary expectations also remain at an elevated level. Given the spread and persistence of inflation, demand-side inflationary pressures need to be contained."

In sync with other global central banks, from now onwards, RBI will be conducting mid-quarter policy reviews, that is review every one-and-a half month after each quarterly review.

“As per schedule, mid-quarter reviews will be in June, September, December and March. They will be by way of a press release, which will provide a rationale for either action or maintenance of the status quo," Subbarao said.

In the policy statement, the governor said that the recovery has consolidated and is becoming increasingly broad-based and there are some concerns about capacity constraints being reached over a wide range of sectors. Monsoon so far, too, has been “significantly better than during last year."

The double-digit growth in the index of industrial production, or IIP, continued during the current financial year with April and May recording a year-on-year growth of 14% with as many as fifteen out of the seventeen industry groups showing positive growth.

However, the current inflation scenario remains “worrisome". While the wholesale price based index has been in double digits since February 2010, inflation, as measured by year-on-year variation in WPI, rose to 10.6% in June from 10.2% a month ago and a revised estimate for March and April pegs the inflation at 11% and 11.2% respectively.

RBI said deregulation in prices of petroleum is welcome for the long run but will have an inflationary impact in the short term. If the global crude oil prices remain stable, the immediate impact on inflation will be about 1% “with second round effects coming through in the months ahead."

RBI pointed out that a potential slowdown in capital inflows is a significant risk as India’s rapid recovery has resulted in a widening of the current account deficit, as imports have grown faster than exports, in this scenario, if there is a slowdown in capital flow, “apart from narrowing the comfortable buffer between the current account deficit and net capital inflows, this may constrain domestic investment, which is critical to achieving and sustaining high growth rates."