RBI combats inflation - increases repo and reverse repo rate
Mar 20, 2010

Author: PersonalFN Content & Research Team

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

The Repo rate has been increased from 4.75% to 5.00%

Similarly, the reverse repo rate has also been increased from 3.25% to 3.50%

The repo rate was last increased in July 2008 by 50 basis points. The reverse repo was last increased in July 2006, by 25 basis points.

The RBI’s move of mid-policy interest rate hike is a surprise for many bankers and money market players, as the next annual Monetary Policy meeting is scheduled soon on April 20, 2010. The RBI explained the move by saying “These measures should anchor inflationary expectations and contain inflation going forward. Wholesale Price Index (WPI) inflation on year-on-year basis at 9.9 per cent in February 2010 has exceeded our baseline projection of 8.5 per cent for end March 2010”. The RBI also expressed concerns over the food inflation spilling over to non-food manufactured goods. It said “more importantly, the rate of increase in prices of non-food manufactured goods has accelerated quite sharply ... taken together; these factors heightened risks of supply-side pressures translating into generalised inflationary process" However the RBI also expressed the fear that rising industrial growth could add to further inflationary pressure in the coming days.

Earlier in the week, the Finance Minister, Mr. Pranab Mukherjee, had explained concerns on inflation saying “inflation is heading to double digits from 9.89 per cent at present, while at the same time not giving up on growth”.

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 will become expensive, as the lending interest rates might move upwards. However banks have mentioned that they will wait till next month before taking a decision on raising rates, (probably wait to see what happens in the April Monetary Policy), since they have recently raised the lending rates on account of the recent Cash Reserve Ratio (CRR) increase of 75 basis points. We at Personal FN too, agree with this stance.

Similarly, the interest rates on fixed deposits are also expected to firm up.

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 the RBI.

We at Personal FN believe that the hike in the repo and reverse repo by 25 basis points is aimed at combating inflation and anchoring inflationary expectations. It also hints at a calibrated exit form the accommodative policy regime.

What to expect in the near future?

There is still ample liquidity in the system, which may encourage RBI to squeeze this excess liquidity further by an increase in CRR or through further rate hikes, in its next annual Monetary Policy2010-11 meeting.

No major changes are expected from banks in their lending rates immediately – bit if this policy trend from RBI continues, the story could be different quite soon!

What should Debt fund investors do?

Debt funds are not the ideal investments when interest rates in the economy are expected to move up. This is because the bond price and interest rates are inversely related to each other. In the current scenario, we recommend that investors stay away from pure income and government securities funds till the Q1 of 2010-11.

Investors with a short-term time horizon would be better off investing in liquid and liquid plus funds for the next 2-3 months; while the medium term investors with an investment horizon of over 6 months can allocate their investments to floating rate funds.

Investors should wait for allocating their money in fixed deposits, till a further increase in deposit rates is introduced by the banks.

What should equity investors do?

We believe that there are opportune times for investors to buy fundamentally sound stocks and/or mutual funds and stay invested for long-term.

Investors should continue to invest in diversified equity funds preferably in a phased manner through SIP, in order to benefit from the current volatility witnessed in the equity markets.