RBI tightens the noose on money supply - Views on News from Equitymaster

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RBI tightens the noose on money supply

May 3, 2011

The Indian central bank declared the first monetary policy for the financial year 2011-12 today. High commodity prices, persistent inflation and expectations of a moderation in demand drove the RBI to tighten the monetary policy noose.

The RBI raised the rates at which it lends to (repo rate) banks by 0.5%. Thus the repo rate now stands at 7.25% from 6.75% previously. In terms of quantum of hike, this is one of the highest since July 2010. The rate at which RBI borrows from banks (reverse repo), is no longer an independent variable. It has been pegged at 1% below the repo rate. The RBI's intention is to have only a single policy rate, which varies depending on its monetary policy decisions. Thus, the reverse repo rate has automatically adjusted to stand at 6.25% from 5.75%.

The RBI reiterated that inflation is a huge threat that cannot be ignored. It poses significant risks to future growth. Thus the central bank is willing to sacrifice some short term growth. This is in order to make sure that the long term Indian growth story stays intact.

A higher savings account interest rate - good or bad?

Pending a final discussion on savings rate deregulation, the central bank decided to increase the savings deposit rate from 3.5% currently to 4%. In the recent period, the spread (difference between interest rates) between savings bank deposit rates and fixed deposit rates have increased sharply. This was due to the adverse liquidity situation in the country. The central bank has decided to increase the savings account rate, benefiting bank customers. The hike in savings account rate was imperative considering that real interest rates (adjusted for inflation) on savings account balances have been in the negative for quite a while now.

This move will impact banks which have a high CASA (current account and savings account) base. SBI, HDFC Bank etc will be seeing margin pressure. While increasing the rate, the RBI has not ruled out savings rate deregulation, thus banks may see further pressure on spreads going forward.

On economic growth and inflation for 2012

High crude oil prices, increased commodity prices and now the RBI's monetary tightening will weigh heavily on economic growth. According to the RBI, growth is expected to slow down in agriculture and manufacturing. Plus, if the global recovery remains weak, external growth may also see a slowdown in the financial year 2011-2012 (FY12).

Based on a normal monsoon, and crude oil prices of around US$ 110 per barrel, the base growth projection is around 8%. Thus the RBI predicts economic growth to be in the range of 7.4% to 8.5% for FY12.

The RBI significantly under predicted inflation rates in FY11. Even after a revision in predictions of the headline inflation (WPI) from 5.5% to 8%, the number still came in higher at 9% in March 2011. In keeping with its conservative monetary policy stance, the RBI predicts WPI inflation to be in the base range of 6% by March 2012 with an upward bias. Inflation will continue to be at high levels for the first half of the year, before easing out in the second half. Either way, slower growth and inflationary pressures do not bode very well for FY12.

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