>MONETARY POLICY: Hawkish stance; more hikes in the offing

The RBI hiked policy rates today – repo by 25bps and reverse repo by 50bps, in
line with our expectations. The central bank also increased its FY11 GDP growth
projection to 8.5% from 8% and fiscal-end headline inflation (March ’11)
forecast to 6% from 5.5% in the last review. The overall stance was hawkish and
the RBI appears to be gearing for a full-blown war against inflation. In our view,
today’s rate hike is effectively 50bps as liquidity is expected to return into the
system in 3–4 weeks, making reverse-repo the effective policy rate. However, we
believe that the RBI is still behind the curve, and that inflation will remain
elevated this fiscal and a risk to growth.

RBI’s hawkish monetary stance; liquidity to ease shortly: The RBI hiked repo by
25bps and reverse repo by 50bps today. We had anticipated either a 50bps hike in
both policy rates or a 25/50bps hike in repo/reverse repo respectively, as against
the consensus expectation of a 25bps hike in both rates. The RBI in its statement
said “With growth taking firm hold, the balance of policy stance has to shift
decisively to containing inflation and anchoring inflationary expectations”. The rate
hikes tell us that the RBI is confident liquidity will return to the comfort zone in 3–4
weeks, when the effective policy rate will be reverse repo, and not repo as is the
case now.

FY11 GDP and inflation projections hiked: The central bank appeared rather
convinced about the strength of India’s economic recovery. However, the concerns
over inflation have become more intense now. The central bank has acknowledged
that inflation has decisively become generalised, citing evidence from sectoral
price inflation as well as other measures (CPI-IW). The RBI raised its FY11 GDP
growth projection to 8.5% from 8% earlier and fiscal-end headline inflation
(March ’11) projection to 6% from 5.5% earlier.

Rate corridor narrowing a positive step: The rate corridor – the difference between
repo (rate at which banks borrow from the RBI) and reverse repo (rate at which
banks lend to the RBI) – has diminished to 1.25 percentage points now from 1.50
earlier. This will result in reduced interest-rate volatility in the money market.
Our GDP and headline inflation numbers remain unchanged: Our FY11 GDP
estimate stands at 7.9%, with some downward bias, while inflation is likely to
average at 8.5%, peaking at ~14% in August before declining and closing the fiscal
(March) at ~6.5%. We continue to believe that the persistently high inflation is
likely to hurt private consumption and investment demand, and poses a significant
risk to economic growth.

More rate hikes this fiscal (at least 75bps): With Delhi’s diminishing reservations
against an aggressive monetary policy stance (due to political-economic realities:
eight states go into elections in the coming 10 months and an opposition devoid of
any credible election agenda), we believe the RBI will try to get back on the curve.
We expect a further 75bps rate hike at least in the current fiscal, while the rate
corridor may narrow further by 25bps. Further, we do not rule out another rate hike
before the next scheduled policy meet on 16 September. The benchmark 10-year
bond yield fell below previous day’s closing (7.67%) just before the policy
announcement. It then rose to peak at 7.72%.

To read the full report: MONETARY POLICY