Battling inflation - RBI’s mid-policy review of Monetary Policy 2010-11

The Reserve Bank of India (RBI) increased its key policy rates as the domestic economic recovery is firmly in place (GDP growth rate at 8.8% for Q1 of fiscal year 2010-11 and IIP for July 2010 at 13.8%) despite the slowdown in the global economic recovery and low private consumption.

 

The steps taken by the central bank in the mid-policy review meeting:

 

The Repo rate has been increased by 25 basis points, from 5.75% to 6.00% and

 

The Reverse Repo rate has been increased by 50 basis points, from 4.50% to 5.00%

 

Thereby narrowing down the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate to 100 basis points

 

However, the Cash Reserve Ratio (CRR) is kept unchanged at 6.00%, taking into account the present liquidity situation.

 

(Personal FN’s expectation was a 25 basis points increase, each in repo and reverse repo rate, thus placing them at 6.00% and 4.75% respectively. We forecasted CRR to remain unchanged at 6.00%.)

 

The other highlights of the monetary policy are as follows:

 

• Bank rate left unchanged at 6.00%.
• Statutory Liquidity Ratio (SLR) has been left unchanged at 25.00%: SLR is that amount which a bank has to maintain in the form of cash, gold or approved securities. The quantum is specified in terms of percentage of the total demand and time liabilities of a bank.

 

Reason for the rate hike:

Inflationary pressures are major concern despite the fact that WPI (Wholesale Price Index) inflation for August has mellowed to 8.51% from 9.97% in July 2010, driven by the new series (with year 2004-05 as the base year) and fading of base year effect. Moreover, when calculated on the earlier series (with year 1993-94 as the base year), the decline is marginal, as the WPI inflation has just fallen to 9.50% from 9.97% in July 2010.

 

(Source: Reuters website)

 

Rising food inflation at 11.47% (as on August 28, 2010) too is a concern. As per the new series, food prices have risen by 14% in August 2010.

 

But nonetheless, taking into account the progress of monsoon, (which will improve the chance of good harvest), and domestic macroeconomic scenario, the RBI expects headline WPI inflation to settle down to 6.00% by March 2011 (Forecasted inflation range given by the Finance Ministry is 5.00% to 6.00% by March 2011).

 

(Personal FN’s forecast for inflation range is 6.50% - 7.00% by fiscal year end)

 

We think that aggressive increase in reverse repo rate by 50 basis points, is a measure taken by RBI to suck the excess liquidity, thereby curb demand side inflation. However, in our opinion core inflation will continue to exist, as the Indian economy continues to trail the growth path.

 

The policy rate action taken by RBI, is also intended to end negative real interest rate regime, by taking actions which do not impede economic growth, but at the same time curb inflationary situation.

 

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 rates might move marginally upwards.

 

Similarly, the interest rates on fixed deposits are also expected to start firming up, as banks will try to manage tight liquidity situation. We think that interest rates on 1 – 2 year fixed deposit may become attractive and range from 6.00% to 8.00%.

 

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, thus enabling the central bank to manage excess liquidity.

 

The RBI believes that the stance taken in the monetary policy is intended to:

 

• Contain inflation and anchor inflationary expectations, without disrupting growth
• Reduce volatility in the overnight call money rates, thereby strengthening monetary policy mechanism
• Continue the process of normalization of the monetary policy instruments

 

GDP estimate: RBI also expects a GDP growth rate of 8.50% for the fiscal year 2010-11 (as forecasted in Q1 review of monetary policy held on July 27, 2010), factoring that monsoon for the current fiscal has been above normal.

 

What should Debt fund investors do?

Debt funds are not the ideal investment in a rising interest rate scenario. 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 October 2010.

 

Hence, investors with a short-term time horizon (of less than 3 months) would be better off by investing in liquid and liquid plus funds for the next 1 ½ month; while the medium term investors with an investment horizon of over 6 months can allocate their investments to floating rate funds and short term income funds. At present we do not expect any major increase in the rates of short term instruments. 3 months and 1 Year Certificate of Deposits (CDs) are at 7.25% and 8.00% respectively, and are already factoring tight liquidity situation along with high interest rates. This is because the markets had already factored in 25 basis points increase in the policy rates (both repo as well as the reverse repo).

 

Investors can also consider investing their money in Fixed Deposits (FDs), as FD rates may now range from 6.00% to 8.00%. One year FDs are currently available at 6.00% to 7.10%.

 

What to expect in the near future?

We believe that RBI will 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, after taking into account the economic factors. Hence, RBI in its next quarter review of monetary policy (scheduled for November 2, 2010), may increase the policy rates (both repo as well as the reverse repo) again by another 25 basis points, and thus reduce LAF corridor between repo and reverse repo rate (which is at present 100 basis points).

 

Further, it is noteworthy that we are yet below the peak of September 2008 (where repo rate was 9.00% and reverse repo was 6.00%). Hence there’s a comfortable space of 300 basis points (on repo rate) and 100 basis points (on reverse repo rate) increase which cannot be ruled out.

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