After expanding by double digits for eight months in a row, India’s factory output moderated to a growth pace of 7.1% in June, the slowest in 13 months and much below consensus estimates. It was the second consecutive month that growth in the Index of Industrial Production, or IIP, had fallen short of analysts’ estimates. Still, factory output expanded by 11.6% in the first quarter of the current fiscal, compared with 3.9% a year ago. Analysts now expect full-year growth to be around 9%.

The annual headline inflation, too, slowed in July more sharply than expected. The wholesale price-based inflation was at 9.97%, ending a five-month streak of double-digit acceleration since February.

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Most importantly, inflation in non-food manufactured goods, which has been the Indian central bank’s primary concern, is showing signs of moderation—6.7% in July, lower than 7.73% in June.

A section of the analyst community has started saying that the moderation in IIP and inflation rate clearly shows that Asia’s third largest economy is far from being overheated and the Reserve Bank of India, or RBI, should press the pause button now. The yield on the benchmark 10-year government bond, which was around 7.7% a month ago, is now inching closer to 8% and banks have also started raising their deposit and loan rates. So there is no need to tighten monetary policy any more, they say.

RBI has raised its repurchase (repo) rate, or the rate at which it drains liquidity from the system, by 100 basis points (bps) and the reverse repo rate, or the rate at which it infuses liquidity, by 125 bps in the current rate tightening cycle.

One basis point is one-hundredth of a percentage point.

I would like to believe that there’s no case for a change in the rate-tightening stance. India’s headline inflation continues to be the highest among the Group of Twenty major economies and real interest rates are still negative. Only the gap between the policy rate and the inflation rate has marginally narrowed. Besides, inflation measured by consumer prices paid by industrial and farm workers continues to be very high.

Before announcing its first six-weekly review of monetary policy on 16 September, RBI will have two sets of data—IIP for July and inflation for August—and both will come down from the current levels. Yet, RBI shouldn’t press the pause button unless it is absolutely sure that the rate hiking cycle is over. This is certainly not the case as no economy can afford to have a policy rate 4 percentage points lower than the rate of inflation. If RBI chooses to keep rates unchanged in September and raise them in its next quarterly review, it will confuse the market. Besides, with the base effect catching up, both the inflation rate and IIP would progressively come down and it will be difficult for RBI to justify a rate increase later.

So there is no debate on whether it should hike the rates in September or not. The debate could be on the extent of the rate hike. Indeed, liquidity is tight in the system and banks are borrowing from RBI daily although the amount is lesser than what they used to borrow in June and July. Redemption of government bonds and government spending have infused money in the system and reduced the deficit. This will continue until mid-September when liquidity will tighten further as Indian corporations pay advance tax on their quarterly profits. In this backdrop, RBI can repeat what it had done in July—a 25 bps hike in the repo rate and 50 bps hike in the reverse repo rate. This will raise the repo rate to 5% and the reverse repo rate to 6% and bridge the gap between the two policy rates, or the corridor, to 100 bps. The other option could be raising both rates by an identical margin, 25 bps each.

RBI has constituted an internal committee to look at the corridor and it can probably wait until the committee releases its report on the ideal gap between the two rates. Personally, I think it could be 100 bps or even less (as too wide a gap encourages volatility) and, hence, a 25 bps hike in repo and 50 bps hike in reverse repo should be ideal in September. This is despite the fall in IIP and inflation.

Monetary transmission

Banks have started raising their deposit and loan rates after a long time. They had not done so despite successive policy rate hikes since March. Interestingly, no bank has changed its base rate, or the minimum loan rate, as yet. They are all raising the benchmark prime lending rate or BPLR—the rate at which they should lend money to their best borrowers—but in reality around 70% of the borrowers raise money at below BPLR.

The base rate has already replaced BPLR, but existing borrowers have been given time to switch from BPLR-linked loans to the base rate. Banks are not raising their base rate as yet as this rate is calculated on their average cost of funds. Even though they have raised their deposit rates, it does not push up the cost of funds overnight as the new rates are applicable to new deposits only while all loans automatically gets repriced when the benchmark rate is raised. The effect of deposit rate hikes on the cost of money will be seen in due course and then banks’ net interest margin (NIM), or the spread between their cost of funds and what they earn on their assets, will shrink.

I am on a small monsoon getaway over the weekend so this column will not appear next week.

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