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Monetary Policy: Inflation is the main target

Sep 16, 2010

In its 5th round of successive interest rate hikes, the RBI reiterated its strong stand against inflation. This move however proved to be a slightly more aggressive than expected. The RBI hiked the repo rate by 0.25% and the reverse repo by 0.5%. These rates will now stand at 6% and 5% respectively, with immediate effect. The central bank had announced in July that it would be shifting to a 6 weekly review of monetary policy. This hike comes as part of its first mid-quarter review of the policy. More frequent meetings will help prevent any surprise rate hikes as well improve the control of key rates.

RBI's act comes on the back of its view that the economic recovery is now showing signs of consolidation. The Indian economy grew at an estimated 8.8% in Q1 of FY11. RBI cited the examples of improving manufacturing growth through the index of industrial production (IIP), which surged 13.8% in July 2010. This improved from 5.8% in June this year. However, the central bank was concerned with the high volatility of the index. This unpredictability raised doubts on how effective the index is at reflecting momentum in the industrial sector.

The good monsoons that the country is receiving currently however raise chances of a robust GDP growth during the current fiscal. The slow recovery of the global economy cause export growth to remain sluggish while the strong domestic recovery has increased demand for imports. As a result, trade deficits, and current account deficits, are widening. However, the government fiscal deficit is expected to remain at around 5.5% of GDP post the successful 3G and BWA auctions. Plus increased interest rates will reduce import demand.

Inflation however still needs to be tamed

The RBI raised concerns on the inflation front. The published wholesale price index (WPI) inflation rate for August 2010 was based on the new series (base year: FY05=100) for the first time. The new series has a better coverage of items with manufacturing products having a slightly higher weight.

Both series, however, indicated similar broad inflation trends. Average monthly WPI inflation for 1QFY11, based on either series, is in double digits, 10.6% (new series) and 11.1% (old series). July, 2010 saw some moderation in inflation. This further continued in August. WPI inflation fell to 8.5% in August from 9.8% in July 2010 as per the new series. Inflation rates although showing some moderation, it has more or less reached a plateau. They are still likely to remain at unacceptably high levels. Thus, the need to implement policy decisions in order to tame prices.

Negative real rates

Another cause of concern by the RBI is the prevalence of negative real interest rates. This has caused deposit growth to slow down for most banks. People with money to save have been looking for higher returns in other places. A slowdown in deposits will in turn reduce credit offtake. To make sure that non-availability of credit would not be a growth constraint, a combination of increased policy rates and declining inflation rates are needed. Thus, the move towards rate hikes from the RBI, despite some moderation in inflation.

Overall, we see RBI's intentions as positive because it shows its resolve to tackle the inflation problem and that of negative real rates in a timely manner.

The hike in rates will lead to a rise in cost of funds for the banks eventually making loans more expensive. This will help drive down consumption to some extent which has been ballooning lately. The tightening of monetary policy that it has done so far has taken the situation close to normal.

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

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