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The repo rate hike of 50 basis points (bps) has clearly been higher than market expectations. The policy stance also remains markedly hawkish, with the Reserve Bank of India staying almost exclusively focussed on containing inflation. The rate hike alone will not be able to tame down inflation meaningfully.
But, the RBI clearly wants to stay ultra-cautious — trying to quash perceptions of “falling behind the curve” to the extent possible. Missing the 2010-11 inflation projection by an unusually wide margin, even after frequent revisions, has possibly turned the central bank all the more vigilant. Along with the policy rate hikes, the RBI also announced a new operating procedure of monetary policy with overnight call rate as the operating target; Repo rate being the single “independently varying policy rate”.
Accordingly, the RBI is set to keep liquidity on a tight leash as well in the coming months so that the call rate remains aligned with the repo rate. The savings rate has been increased 50 bps to 4 per cent. All these moves cumulatively point towards further upward pressures on banks' funding costs and interest rate spectrum in general.
Distant priority
The central bank recognises that policy rate hikes at the current level of systemic pressure on liquidity and interest rates are no longer “costless” for growth. But, currently that consideration is nothing more than a distant second priority for the RBI. The RBI's FY11-12 GDP growth projection of 8 per cent is distinctly lower than that of the government's 9 per cent.
Indeed, while consumption can still provide a stable base for growth, high inflation, tight liquidity, high borrowing costs, alleged high-level corruption, and global uncertainties do not augur well for investment demand in 2011-12. Manufacturing and construction activities can be impacted the most.
More hikes likely
However, while one can observe a decent long-term correlation between industrial activity and core inflation in India, this relationship is turning markedly weaker in recent months.
Thus, while the trend in industrial production growth is in a unidirectional downward drift, it will not necessarily offer any respite for inflation. Rather, domestic prices continue to face the threat of second-round effects of rising input costs and energy prices. The current set of measures is, thus, by no means, the end of the rate hike cycle either.
The author is Chief India Economist, Barclays Capital.)
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