RBI governor D. Subbarao. (File photo)

The 25 basis point hike in the repo rate, at which the central bank injects liquidity into the financial system, was in line with market expectations. The repo rate is now at 8.25%.

The reverse repo rate, through which RBI drains out excess liquidity, stands adjusted at 7.25% as the corridor between the two rates is supposed to remain constant at one percentage point.

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From our archive

12 Sept, Banker’s Trust |Another rate hike cannot be ruled out

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Soon after the hike, the yield on the 10-year benchmark bond went up to 8.36% from 8.31% before policy. By the time of filing this story, bond yields had recovered to 8.34% as the market had already factored in a 25 bps rate hike. Equity index of the BSE, Sensex had fallen to 16990 after the policy from 17120 before the announcement but soon recovered to 17056 points.

Justifying the hike in rates, RBI said it would be “premature" for it to reverse its hawkish stance in the current scenario.

“… with the likelihood of inflation remaining high for the next few months, rising inflationary expectations remain a key risk," RBI said in its mid-quarter policy statement.

“This makes it imperative to persevere with the current anti-inflationary stance," it said in its policy statement, dashing the hopes of industry lobbies that RBI will pause in its rate hiking cycle or reverse its stance.

While the central bank acknowledged that its hawkish monetary stance is contributing to the slowdown in domestic demand and that risks to the growth projection for 2011-12 made in the July Review are “on the downside," it indicated that firms are still able to pass on the high input costs to their consumers and as such they are not overtly affected by the rate hikes.

The rate hike comes despite signs that the Indian economy is losing steam. The latest data on factory output showed that industrial production growth had slumped to 3.3% in July, far below consensus estimates. But inflation in August rose to 9.78%, the highest in 13 months, even as an increase in fuel prices from Thursday midnight and a fall in the value of the rupee could add to inflation pressures in the coming months.

The central bank has been under pressure from the government and industry associations who fear that further increases in interest rates could harm economic growth at a time when the global economy is facing turbulence.

RBI said inflation remains “high," “generalized" and “much above the comfort zone of the Reserve Bank." Both headline and non-food manufactured products inflation are at “uncomfortably high levels," the central bank’s statement read.

RBI, in its first quarter review in July, had said it expected inflation to remain high till the first-half of the year and then taper off to end the financial year to around 7%.

"We expected this hike and are very happy that the RBI did what was to be done and did not let itself get swayed by market sentiments," said Indranil Pan, chief economist of Kotak Mahindra Bank.

“With inflation close to 10% and showing no signs of easing and with crude oil at $115 per barrel this was only a prudent move. They cannot afford to step aside and clear the channels for demand," Pan said.

RBI expected Friday’s policy actions will reinforce the impact of past policy actions to contain inflation and anchor inflationary expectations, and going forward its stance will be influenced by inflation coming down.

“… a premature change in the policy stance could harden inflationary expectations, thereby diluting the impact of past policy actions."

According to Saugata Bhattacharya, chief economist of Axis Bank Ltd, this could be the last hike by the central bank in the current scenario.

“We think that this is the last of the rate hikes because from here on inflationary expectations will ease because of a good monsoon harvest and also because crude oil prices are unlikely to move much from the current levels," he said.