RBI increases policy rates to curb inflation!

The Reserve Bank of India (RBI) increased its key short-term lending and borrowing rates by 25 basis points each with immediate effect on July 2, 2010.

The repo rate has been increased from 5.25% to 5.50% and

Similarly, the reverse repo rate has also been increased from 3.75% to 4.00%

Reason for an "intermediate" rate hike

The decision of intermediate rate hike was taken by the central bank in order to combat spiralling double digit inflation.

(Source: www.reuters.com)

The Wholesale Price Index (WPI) inflation for the month of May 2010 (released in June 2010) inched-up in doubled digits at 10.16%, after showing signs of cool-off in the previous month (9.59% in April 2010).

Moreover, WPI inflation numbers for February and March were also revised upwards to 10.06% and 11.04% respectively. Also, the chance of an upward revision in April’s inflation number fuelled this increase. RBI also appeared to be vigilant about the fact that, inflation is getting generalised and demand-side pressures are building up. The central bank said, "Non-food inflation and fuel price inflation are accelerating and the impact of increase in fuel prices will add up to 100 basis points to inflation immediately, with more effects in the coming months". We think that the surge in inflation as contributed by the rise in oil prices, was not on account of demand side price pressures building up; but on account of supply side price pressures build up due to deregulation of oil prices, which link them to international crude oil prices. A rate hike in the domestic economy may not be able to reduce the oil prices in the domestic market, due to its linkage with the international crude oil prices. Hence RBI’s stance of controlling fuel price inflation may not be achieved by this rate hike.

Justifying this intermediate rate hike, RBI’s Deputy Governor, Dr. KC Chakrabarty said, "We had to control credit demand, especially unproductive demand has to be curtailed,’’ he also added saying "If inflation rises further, there will be more rate hikes". The central bank statement also mentioned that the measures should contain inflation and anchor inflationary expectations going forward, while not hurting the recovery process.

Finance Minister, Mr. Pranab Mukherjee also reacted to the policy rate hike by saying, "These measures are desirable given that core inflation has risen and credit situation is tight".

What does the rate hike mean and its impact?

The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. A hike in the same means, an increased cost of borrowings for commercial banks. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may become expensive, as the lending interest rates might move upwards.

Similarly, the interest rates on fixed deposits are also expected to firm up. But, we think that this would take place only after the next monetary policy review meeting, scheduled for July 27, 2010.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. A hike in the same means, it will be more attractive for commercial banks to park their surplus funds with RBI.

What to expect in the near future?

We believe that RBI will certainly continue adopting the calibrated exit path by raising policy rates by 25 basis points at each step to normalise policy rates and make it more relevant to the current high economic growth and spiralling inflation. Hence, RBI in its next policy review meeting (scheduled for July 27, 2010) may increase the policy rates again by another 25 basis points.

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