Why did RBI change its policy rate a month before the date of its monetary policy meeting? RBI says it’s because the inflation projections made at its January meeting have been exceeded. Kotak Mahindra Bank economists Indranil Pan and Shubhra Mittal point out that “manufacturing goods inflation (excluding food articles) jumped to 4.3% from 0.8% in December 2009". Or, could it be because, three days before RBI’s move, the International Monetary Fund (IMF) had said about India: “Currently, the policy rate is some 200 bps (basis points) below the neutral rate. Given the monetary transmission lags and inertial behaviour in short-term interest rates, a timely and gradual normalization of the monetary stance could ensure that inflation expectations remain well anchored?" One basis point is one-hundredth of a percentage point.

What will be its impact? Liquidity is tight at the moment because of the outflows on account of advance tax and, in fact, on Friday, Rs400 crore was borrowed from RBI through repos at 4.75%. But the money sucked out will come back as the government spends it and it’s only when banks start to borrow from RBI that the higher repo rate will bite. Till then, all that will happen is that banks will earn more on the amounts they keep with RBI through reverse repos. RBI must be expecting that banks will start borrowing from its repo window soon. Will they? Well, the credit-deposit ratio of the banking system was 70.92% on 15 January and it was lower at 70.8% on 26 February, the latest date for which numbers are available. No signs of any pressure to borrow intensifying there. But the central bank is looking ahead. The Index of Industrial Production (IIP) numbers show a spurt in capital expenditure, part of which will be borrowed from banks.

HSBC Holdings Plc economist Robert Prior-Wandesforde refers to a National Council of Applied Economic Researchsurvey which “indicates that 97.4% of companies were ‘operating at or above an optimal level of capacity’ in January this year. This is very close to its all-time high of 98.6% in January 2007." Plus, the banking system has sizeable undisbursed sanctions.

After significantly outperforming the Bombay Stock Exchange’s (BSE) Sensex in 2009, the BSE Auto and BSE Realty indices have underperformed this year, on worries over rising interest rates.

The Bankex, however, has been doing better, perhaps because banks are expected to benefit from higher growth. We should expect a short-term reaction on account of the hike, though, because it has come earlier than expected.

Finally, what were policy rates like when RBI started to tighten during the last cycle? At that time, RBI first started to hike in October 2004, about one-and-a-half years after the stock market bull run started and after the economy grew by 8.5% in 2003-04. Wholesale price inflation was around 7% in October 2004. The reverse repo rate was raised from 4.5% to 4.75%, while the repo rate was left unchanged at 6%. The cash reserve ratio (CRR) had been raised in September 2004 by 50 bps to 5%.

This time around, inflation is much higher, the CRR is at 5.75%, the reverse repo rate at 3.5% and the repo rate at 5%. Clearly, there’s more to be done.