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Will inflation be tamed?

Will the hikes in policy rates after the first quarter policy review by the Reserve Bank suffice to tame inflation?

In the first quarter review of monetary policy 2010-11, the Reserve Bank of India (RBI) raised the repo rate (the rate at which it lends to banks) by 25 basis points (bps) to 5.75 per cent. It increased the reverse repo rate (the rate at which it borrows from banks) by 50 bps to 4.50 per cent. However, the bank rate and the cash reserve ratio (CRR) of scheduled banks were left unchanged at 6.0 per cent.

Why the hikes
While economic growth appears to be firmly entrenched, inflation has become a worry. The main purpose of the monetary policy measures of July 27 was to contain inflation. Besides, policy rates were cut steeply in the wake of the global financial crisis of 2008-09 and need to be normalised. Inflationary pressures. Wholesale Price Index (WPI) inflation moved to double digits in February 2010 and has remained there since. Even as food price inflation remains elevated, manufactured goods inflation has also assumed significant proportions.

Strong domestic recovery. The domestic recovery is firmly in place. While the Indian economy grew at the rate of 7.4 per cent in 2009-10, RBI has raised its projection of real GDP growth for FY11 to 8.5 per cent.

Global uncertainties. Even as the domestic picture improves, the prospects of a sustained global recovery has become uncertain.

What the experts think
Most market experts feel that the hikes were in line with expectations. They also believe that more rate hikes could follow over the next few months if inflation does not come under control. According to Lakshmi Iyer-head (fixed income and products), Kotak Mutual Fund, “RBI wants to ensure that excess liquidity does not dilute policy rate effectiveness. It also wants to reduce the volatility in overnight rates. Also it now seems that we would see the repo rate being the operational rate in the near term as the system migrates from surplus to deficit liquidity mode.”

However, Ramanathan K, chief information officer (Single Manager), ING Investment Management India says: “The increase in reverse repo rate by 50 bps was above market expectation. The narrowing of the liquidity adjustment facility (LAF) corridor would help in effective transmission of the tightening bias under easy liquidity conditions.”

Given the recent frequent inter-policy rate actions and the need for a faster calibrated exit, RBI has also instituted a mid quarter review of monetary policy. “This will reduce the negative surprise element of such inter-meeting policy actions,” says Ramanathan.

Other consequences
One likely outcome of these policy measures will be hikes in bank deposit rates. “Given the environment of negative real interest rates coupled with low deposit growth, a clear message from RBI to the banking system is to hike deposit rates. We expect this to translate into higher lending rates in subsequent months,” says Vikram Kotak, chief investment officer, Birla Sun Life Insurance.

Abheek Barua, chief economist, HDFC Bank expects further rate hikes which would lead to flattening of the yield curve in the new future.

Deposit rate hikes begin
Banks have begun announcing higher deposit rates. HDFC Bank has raised deposit rates by up to 75 bps while Central Bank of India, Lakshmi Vilas Bank and Allahabad Bank have raised their deposit rates by 50 bps. Punjab National Bank has also hiked its term deposit rates by 75 bps. It is likely that other banks will also announce hikes in due course.