India’s central bank will review its monetary policy on Tuesday. There is a near consensus among bankers, bond dealers as well as analysts on three things in the run up to the review.

First, the gamble of the Reserve Bank of India (RBI) on pressing the pause button and not raising the policy rates in its December review did not pay off. Governor D. Subbarao has all along been saying that one should not read too much in its inaction in December and that it was a “comma" and not a “full stop" to the rate hike cycle, but the fact remains that had RBI continued with its baby steps in rate tightening (read: a quarter percentage point hike), it would not have shown desperation in fighting rising inflation in the world’s second fastest growing major economy.

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Second, the central bank’s projection for inflation for fiscal 2011 will turn out to be wide of the mark. Against a projection of 5.5%, the wholesale priced-based inflation in December was 8.43%, up from November’s 7.48%. Meanwhile, the October inflation figure has been revised upwards to 9.12%, making the average inflation for the year 9.4%. This will leave RBI with no choice but to raise its inflation projection for the fiscal year-end.

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Finally, it’s a given that RBI will hike its policy rates on Tuesday even though there is no consensus on the quantum of the rate hike. Most analysts are expecting a 25 basis points (bps) rate hike in both the policy rates—repo and reverse repo. This will take the repo rate, or the rate at which RBI infuses liquidity into the system, to 6.5%, and the reverse repo, or the rate at which the central bank drains liquidity, to 5.5%. One basis point is one-hundredth of a percentage point.

I will not be surprised if Subbarao gets a bit more aggressive this time and goes for a 50 bps hike, lifting the repo rate to 6.75% and reverse repo rate 5.75%.

Why should he do that? After all, he believes in a calibrated approach. In 2010, he has raised the repo rate six times but always by 25 bps and not more. Indeed, he has increased the reverse repo rate by 50 bps twice but that did not have any impact on the overall interest rate architecture. That was done primarily to bridge the gap between the two rates.

Unlike most other central banks that have only one policy rate, RBI has two policy rates and the gap between the two rates, or the corridor, is an indication of what the overnight interbank rates should be. By shrinking the gap, RBI wanted to bring down the volatility in the overnight rates. Otherwise, it has no other significance as in a liquidity-starved situation, what has been the case for quite sometime now, repo is the policy rate, since RBI lends money to banks at this rate.

Subbarao needs to be more aggressive since time is fast running out for RBI for fighting inflation. Theoretically, one can argue that the rise in inflation is primarily driven by food articles and that’s a supply-side phenomenon, which cannot be addressed by the central bank and that the so-called core inflation or non-food, non-oil inflation is not alarmingly high, but such arguments will not solve the problem.

There is a high correlation between core inflation and food and energy prices and as an International Monetary Fund study has suggested, “Food and energy prices feed through quickly to core inflation…through inflation expectations, wages and input costs."

While average inflation is more than 9%, commercial banks have been raising money from the central bank at 6.25% through its repo window. This means the real interest rates are in the negative territory, and despite six rounds of rate hikes last year RBI has been following an accommodative monetary policy. The credit growth of the banking industry this year has been 24.4% against RBI’s target of 20%. Why should the central bank keep its cheap money window open for banks that are giving more loans to their borrowers than what the banking regulator has projected?

RBI must make money more expensive. It can even ration the money flow into the system. For instance, it can limit a bank’s access to cheap money from the repo window and link it to its incremental credit deposit rate, or overall loan portfolio. As long as the banks are comforted that they can raise money from RBI to take care of their daily asset-liability mismatches, they will not go slow on building their loan book. RBI can restrict banks’ access to its repo window and combine it with a 25 bps hike. The other option before it is raising the rate by a higher dose, 50 bps.

Besides fighting inflation, RBI also needs to clear the uncertainties in the market before April, when the Indian government launches its money raising plan for the next fiscal. The government would need to borrow at least 3.6 trillion next year, net of redemptions of bonds, to take care of its fiscal deficit.

It will be extremely difficult to raise money from the market unless there is clarity on the interest rate outlook. A 50 bps rate hike now and another 25 basis points hike in March, in the central bank’s mid-quarter review, will push up the repo rate to 7%, close to a neutral zone, as inflation is expected to drop to around 7% by the end of the fiscal year.

The slump in factory output to an 18-month low of 2.7% in November should not deter RBI from a 50 bps rate hike as factory output data has been volatile for months but there is no obvious sign of growth slowing. Inflation is a bigger evil now and if the central bank is able to fight it successfully and bring down inflation expectations, growth momentum can be sustained automatically. After a series of baby steps, it’s time for Subbarao to take a giant leap.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at