RBI goes by the script, hikes rates by 0.25%

The Reserve Bank of India (RBI) stuck to its trajectory of calibrated rate hikes in the current credit policy too. It hiked the repo rate by 25 basis points to 6.5% and the reverse repo rate also by 25 basis points to 5.5%. The repo rate is what banks pay to the RBI to borrow funds to meet short term liquidity needs and the reverse repo rate is what they get from the RBI, when they park surplus funds with the central bank.

There were some fears –though few were convinced the RBI would do it– that rates could go up by 50 basis points, to contain runaway inflation. The RBI did hike its inflation expectations, however, from 5.5% to 7% by March 2011. The primary component of inflation, food, fuel and minerals, has been showing a sharp jump, due to a spike in the prices of vegetables and an increase in fuel prices. The price of crude oil has been rising, up from $85 per barrel in November 2010 to $97.

The RBI’s move may have its reasons. In the past, when the RBI had hiked rates, the transmission effect was weak. That is, while the repo rates went up, the market rates did not, particularly on the deposits side. It is only in recent months that banks have accelerated the pace of deposit rate hikes. So, even if the RBI does not do much by way of signalling, the market itself is playing catch-up, so interest rates may increase further without any intervention.

This could be supported by the scenario that is building up on the deposits’ front. Banks are giving out loans at a rate that is faster than the growth in deposits. The incremental non-food credit-deposit ratio (that is the absolute change in loans over the absolute change in deposits) is at 102%, in the end-December 2010 period, compared to 58% a year ago. The RBI continues to be worried about tight liquidity conditions. Banks, it would appear, would persist with deposit rate hikes in the near term, to improve deposit growth, which will eventually feed into higher loan rates as well.

The key reason for high inflation is fuel and food prices, both of which are not under the RBI’s control. It can only contain the spill over effect into manufacturing, which is visible but not alarming as of now. Recent industrial growth numbers have been volatile, and if there is moderation, that too could limit inflation.

If the RBI can be accused of being behind the curve in hiking interest rates, the government has not woken up from its fiscal stimulus induced slumber yet. The next review by the RBI will be the mid-quarter one in March. By then, the government’s Budget would be out, and its strategy to tackle the fiscal deficit will become clear. An attempt to hike revenues and limit spending will be what the RBI will be looking for. A more balanced fiscal situation will make the RBI’s job easier. Food inflation too can be tackled by the government more effectively.

By March, if food inflation eases, and government finances look better, the RBI’s moderate move today would have been the right step. If these events do not play out, the RBI can always hike rates further. Doing that today may have resulted in the RBI’s hawkishness being blamed for everything wrong with the economy, as has happened on some past occasions.

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