Weeding out the inflation bug: RBI's third quarter policy review

The Reserve Bank of India (RBI) in its third quarter review of Monetary Policy 2010-11 raised its key policy rates by 25 basis points as inflation remained above the tolerance levels of the central bank. The rate hike was despite tight liquidity situation prevailing in the system, right since October 2010, due to mega issues both in the equity as well as the debt segment of the capital market and advance tax obligations.

 

Thus now the policy rates are as under:

 

Repo rate increased by 25 basis points from 6.25% to 6.50%; and

 

Reverse Repo rate increased by 25 basis points from 5.25% to 5.50%

 

Thereby maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points.

 

The Cash Reserve Ratio (CRR) is kept unchanged at 6.00%.

 

(PersonalFN expected policy rates (both repo as well as the reverse repo) to increase by 25 basis points, in a move to tame inflation)

 

Statutory Liquidity Ratio (SLR) has also been kept unchanged at its last reduced level of 24% (In the third quarter mid-review of monetary policy 2010-11 on December 16, 2010 it was reduced from 25% to 24%.) as tight liquidity situation prevailed.

 

Bank rate on the other hand has been left unchanged at 6.00%.

 

Reason for such a policy stance :

 

• Inflationary pressures
  
  The RBI is at present worried about inflationary pressures building in on account of spiraling prices of primary food articles (Food inflation was at 15.52% for the week ended January 8, 2011) and stickiness of non-food manufacturing articles. Moreover with crude oil price surging new highs ($ 96.95 per barrel as on January 24, 2011) and chances of it crossing the $ 100 per barrel mark has elevated the possibility of a “spill over effect” into generalised inflation (i.e. WPI inflation). In the month of December 2010, WPI has already shown an uptick of 95 basis points by rising from 7.48% (in November 2010) to 8.43%. Moreover global commodity prices are on an upswing.
   

  

  (Source: Office of Economic Advisor, PersonalFN)

   

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



• Robust economic growth rate registered by India
  
  Despite the uncertain global recovery our country’s economic growth has moved towards the pre-crisis growth trajectory, as reflected by the 8.9% GDP growth in the first half of 2010-11, due to the following factors:
   
  • Strong domestic demand
  • Increase in private consumption and investment
  • Improving external demand
  
  
  Moreover robust corporate sales, indirect tax collections, advance tax payments and leading indicators of service sector activity have also gone up suggesting persistence of growth momentum.


• Global economic situation
  
  In the recent period the global economic situation has also improved. The uncertainty with regard to global recovery, which was prevailing at the time of the second quarter review of the monetary policy 2010-11, has reduced with the US economy showing signs of stabilising. As far as the Euro zone is concerned, yes there is still uncertainty due to the situation of “debt overhang”, but overall there’s an improvement in the global economic sentiments.

 

Expected outcome from the policy stance:

The central bank’s stance of increasing policy rates by 25 basis points is expected to:

 

• Contain the spill-over from rise in food and fuel prices to generalised inflation.
• Rein in rising inflationary expectations, which may be aggravated by the structural and transitory nature of food price increases
• Be moderate enough not to disrupt growth
• Continue to provide comfort to banks in their liquidity management operations

 

What does the policy stance mean and its impact?

 

The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. Increasing repo rate means, there will be increase in the borrowing cost of commercial banks. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may go up, as the commercial banks in the country may hike lending rates.

 

Similarly, the interest rates on fixed deposits are also expected to move up from the current levels. At present 1 yr FDs (Fixed Deposits) are offering interest in the range of 7.00% - 8.00% p.a.

 

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Increasing them will result in commercial banks continuing to enjoy higher interest rates for parking their surplus funds with RBI.

 

The Statutory Liquid Ratio (SLR) is the amount that the commercial banks require to maintain in the form of cash, or gold or govt. approved securities before providing credit to the customers. Keeping them unchanged would help in keeping a check on the prevailing liquidity situation.

 

GDP estimate:

 

With the risk in growth in F.Y. 2010-11 mainly being on the upside, the RBI has retained the baseline projection of real GDP growth at 8.5% (as set out in the second quarter review of monetary policy of July 2010) taking into account the following factors:

 

• Food inflation remaining at elevated levels for more than two years now
• Non-food manufacturing items remaining at sticky levels
• Several industries operating close to their capacity levels
• Widening current account deficit (it has increased from U.S. $ 12.1 billion in Q1 of 2010-11 to U.S. $ 15.8 billion in Q2 of 2010-11)

 

What should Debt fund investors do?

 

The central bank’s stance of increasing the policy rates by 25 basis points reveals the central bank vigilance in taming intolerant levels of WPI inflation, in the scenario of expanding Indian economy. But as food inflation and crude oil prices soar, the “spill over” may happen to generalised WPI inflation, thus building in inflationary pressures going forward, tempting the RBI to adopt its calibrated exit stance.

 

Hence, given that we are still in a rising interest rate scenario, as of now longer tenure debt mutual funds may not be an ideal investment for you; as bond prices and interest rates are inversely related to each other.

 

In the current scenario, you are recommended to stay away from long term income and Government securities funds till RBI’s next mid-quarter monetary policy review meeting schedule for March 17, 2011.

 

Hence, if you have a short-term time horizon (of less than 3 months) you would be better off investing in liquid funds for the next 1 ½ month or liquid plus funds with a 3 to 6 months horizon; while if you have a medium term investment horizon (of over 6 months), you may allocate your investments to floating rate funds. Short term income funds should be held strictly with a 1 year time horizon. While one can even consider Fixed Maturity Plans (FMPs) of 3 months to 1 year (strictly hold till maturity) as the short term rates are attractive and these FMPs can generate attractive yield for the investors. 14 to 15 months FMPs can also be considered in order to gain attractive post tax returns by availing the double indexation benefits.

 

You can also consider investing your money in Fixed Deposits (FDs). At present 1 yr FDs are offering interest in the range of 7.00% - 8.00% p.a.

 

Refrain from investing in long-term income funds and Government securities funds till the next mid-quarter review meeting of monetary policy (scheduled on March 17, 2011), as we see policy rate hike from RBI (in an attempt to tame inflation); which would then make long-term debt papers more attractive.

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