RBI hikes interest rates

In a surprise move today, the RBI has raised its key policy rates. It has raised the repo and reverse repo rates by 0.25% each. These rates will now stand at 5.5% and 4% respectively, and with immediate effect. This hike comes just ahead of the July review of the monetary policy for 2010-11.

So why has the RBI suddenly decided to raise these rates now? After all, it did nothing in the previous month when inflation was anyways running high!

RBI's act comes on the back of its views that the economic recovery is now showing signs of picking pace. It has cited the examples of improving manufacturing growth and rising exports. It has also hinted at the credit pickup in the banking sector. Then, the good monsoons that the country is receiving currently also raise chances of a robust GDP growth during the current year. The central bank has also raised its concerns on the inflation front. All these factors have forced it to raise interest rates at the current juncture.

Anyways, the RBI has also given a reason why it did not act early in June. It was because the financial system was then dealing with liquidity pressures. These were triggered by the sudden build-up in the government's cash balances post the 3G spectrum and broadband wireless access auctions. As such, there was already an artificial leash on credit. The RBI believes that the liquidity situation has eased since then. And thus the rates have been hiked now. It expects today's hike to help control inflation while not hurting the recovery process. The rate hike is in line with what we had been expecting the RBI to do. Given that inflation was continuing to defy the bank's attempts to rein it within permissible limits, it was only a question of 'when' and not 'whether' the rates will be raised.

As per reports, however, most banks are not looking to toe the RBI line and raise their interest rates. They are in fact waiting for more concrete signals from the central bank in its 27th July review of monetary policy. The banking sector is seeing just a nascent recovery in credit off-take. Given this, and the high level of competition, banks will like to wait for some time before spoiling the party for the borrowers, and for themselves as well!

Overall, we see the RBI's intentions as positive because it shows its resolve to tackle the inflation problem in a timely manner. But how will the markets react in the short run is anybody's guess. Investors in auto and realty stocks, however, might not like the RBI's move. This is considering that companies from these sectors flourish in a low interest rate environment, and suffer when rates rise.

Whatever be the reaction of the markets on Monday, we advise you to not act in haste.

Note: Repo and reverse repo rates are short-term rates at which the RBI lends (repo) and borrows (reverse repo) money from commercial banks.