RBI hikes repo rate, growth comes second to price stability

The Reserve Bank of India’s credit policy announcements met expectations, except of those people who thought today will signal the end of the rate hike juggernaut. The few who feared the RBI may hike the repo rate by 50 basis points were off the mark, however. The majority were expecting a 25 basis point hike, which is what the central bank has done.

The repo rate (the rate at which banks borrow short term funds from the RBI) has been hiked by 25 basis points to 8.25% and other rates such as the reverse repo rate (which the RBI pays to banks to park short term surplus funds) have increased in tandem.

The RBI’s statement shows it is concerned about the deteriorating global economic outlook, particularly as fears grow of a slowdown in the developed world, and the impact this slowdown may have on global GDP growth.
Domestic growth indicators are showing some moderation, it said, in a reference to the recently released Index of Industrial Production numbers. But inflation is still at uncomfortably high levels, from its viewpoint. While inflation is expected to moderate towards end-2011-12, at present it is expected to remain high. Hence, it will need to maintain the current anti-inflationary stance.

India’s economic growth may show some worrying signs, but in relation to what is happening elsewhere, its growth still appears quite resilient, said the central bank.

Inflation as measured by the Wholesale Price Index was 9.8% in August 2011, compared to 9.2% in the previous month. These numbers are usually revised upwards and it is likely that actual inflation has crossed 10% in August.
Money supply growth is higher at 16.7% than the projected 15.5%. More money sloshing around in the system could also aggravate inflation. Credit growth (excluding agriculture) too has been quite healthy at 20.1%, compared to the 18% projection. Both indicate that consumer demand is relatively unaffected. In fact, the IIP data did show that consumer sectors did much better than capital goods or intermediate sectors.

RBI’s guidance: Despite inflation losing momentum a bit, the levels are way beyond the RBI’s comfort levels. The RBI will watch out whether the cumulative hike in interest rates leads to slower economic growth, and hence lower inflation by the end of 2011-12. It will seek to dampen inflationary expectations and will hence persist with its current stance.

What this means is that if inflation shows definite signs of moderation in a few months, the RBI may not hike rates further. But if inflation rises, for whatever reason, the RBI may hike rates again. In sum, the RBI considers its job of controlling inflation, at best, as work in progress.

The fuel price pack will contribute to inflation, joining food and manufactured products. Petrol prices have been hiked by about 5%. The fall in the rupee is being touted as the key reason. If true, then other fuels will become expensive as well. And there will be a trickle-down effect at the industrial level.

RBI’s unflinching attack on inflation has implications for various stake-holders. Banks will continue to face an upward pressure in their cost of funds. The pass-through will lead to higher interest rates, which could affect consumer demand. Companies will find their cost of funds increase, and may be affected by slower consumer demand as well.

The stock markets appear more relieved that the 50 basis point rate hike fear was unfounded. At the time of posting, the BSE Sensex was up by about 190 points. As far as what slowing demand may do to corporate performance, it appears they are buying the logic that India will still outperform the developed world, and hence portfolio flows will continue to be healthy. The September quarter results will offer the first reality check to investors.

Read the release from the RBI here.

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