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RBI’s first quarter review of Monetary Policy 2010-11 – A stride to tame inflation!

The Reserve Bank of India (RBI) increased its key policy rates as the domestic economic recovery is firmly in place (GDP growth rate was 7.40% in fiscal year 2009-10) despite weak global economic outlook and insignificant contribution by the agriculture sector.

The central bank increased the rates as under, thus narrowing down the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate to 125 basis points

The Repo rate has been increased by 25 basis points, from 5.50% to 5.75% and

The Reverse Repo rate has been increased by 50 basis points, from 4.00% to 4.50%

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

(PersonalFN's expectation was a 25 basis points increase, each in repo and reverse repo rate, thus placing them at 5.75% and 4.25% 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 becoming more exacerbated, as inflation remained in double-digit space for five consecutive months (since February 2010). Moreover, the deregulation of fuel prices (in the last week of June 2010), may also lead to headline WPI inflation for July 2010, sail in double-digits and thus be a cause of concern.

(Source: Reuters website)

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 (thereby revising its earlier projection of 5.50% as given in April 2010 policy review), and make it within the forecasted inflation range of 5.00% to 6.00% given by the Finance Ministry.

(PersonalFN'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.

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. But, we think that interest rates on fixed deposit may become attractive (when above 7.50%) only after the next mid-quarter review of monetary policy, scheduled for September 16, 2010.

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, while being prepared to respond to any further build-up of inflationary pressures

  • Maintain an interest rate regime consistent with price, output and financial stability

  • Actively manage liquidity to ensure that it remains broadly in balance so that excess liquidity does not dilute the effectiveness of policy rate actions

GDP estimate: RBI also expects a GDP growth rate of 8.50% for the fiscal year 2010-11, thus revising its earlier forecast of 8.00%, as revealed in April 2010 monetary policy review. This upward revision was made after factoring progress of monsoon and the prevailing global macroeconomic scenario.

What should Debt fund investors do?

Debt funds are not the ideal investments 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 September 2010.

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

Investors should refrain from investing immediately in fixed deposits till a further increase in deposit rates is offered by banks. One year bank FDs would be attractive only above 7.50%. One year FDs are currently available at 5.00% to 6.50%.

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. Hence, RBI in its next mid-quarter review of monetary policy (scheduled for September 16, 2010), may increase the policy rates again by another 25 basis points, and maintain the narrow LAF corridor between repo and reverse repo rate.

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 150 basis points (on reverse Repo) and 300 basis points (on repo rate) increase which cannot be ruled out.

Disclosure: No Positions