The RBI hiked policy rates today – repo by 25bps and reverse repo by 50bps, inline with our expectations. The central bank also increased its FY11 GDP growth projection to 8.5% from 8% and fiscal-end headline inflation (March ’11) forecast to 6% from 5.5% in the last review. The overall stance was hawkish and the RBI appears to be gearing for a full-blown war against inflation. In our view, today’s rate hike is effectively 50bps as liquidity is expected to return into the system in 3–4 weeks, making reverse-repo the effective policy rate. However, we believe that the RBI is still behind the curve, and that inflation will remain elevated this fiscal and a risk to growth.

RBI’s hawkish monetary stance; liquidity to ease shortly: The RBI hiked repo by 25bps and reverse repo by 50bps today. We had anticipated either a 50bps hike in both policy rates or a 25/50bps hike in repo/reverse repo respectively, as against the consensus expectation of a 25bps hike in both rates. The RBI in its statement said “With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations”. The rate hikes tell us that the RBI is confident liquidity will return to the comfort zone in 3–4 weeks, when the effective policy rate will be reverse repo, and not repo as is the
case now.

FY11 GDP and inflation projections hiked: The central bank appeared rather convinced about the strength of India’s economic recovery. However, the concerns over inflation have become more intense now. The central bank has acknowledged that inflation has decisively become generalised, citing evidence from sectoral price inflation as well as other measures (CPI-IW). The RBI raised its FY11 GDP growth projection to 8.5% from 8% earlier and fiscal-end headline inflation (March ’11) projection to 6% from 5.5% earlier.

Rate corridor narrowing a positive step: The rate corridor – the difference between repo (rate at which banks borrow from the RBI) and reverse repo (rate at which banks lend to the RBI) – has diminished to 1.25 percentage points now from 1.50 earlier. This will result in reduced interest-rate volatility in the money market. Our GDP and headline inflation numbers remain unchanged: Our FY11 GDP estimate stands at 7.9%, with some downward bias, while inflation is likely to average at 8.5%, peaking at ~14% in August before declining and closing the fiscal (March) at ~6.5%. We continue to believe that the persistently high inflation is likely to hurt private consumption and investment demand, and poses a significant risk to economic growth.

More rate hikes this fiscal (at least 75bps): With Delhi’s diminishing reservations against an aggressive monetary policy stance (due to political-economic realities: eight states go into elections in the coming 10 months and an opposition devoid of any credible election agenda), we believe the RBI will try to get back on the curve. We expect a further 75bps rate hike at least in the current fiscal, while the rate corridor may narrow further by 25bps. Further, we do not rule out another rate hike before the next scheduled policy meet on 16 September. The benchmark 10-year bond yield fell below previous day’s closing (7.67%) just before the policy announcement. It then rose to peak at 7.72%.

To read the full report: MONETARY POLICY