RBI to pause if inflation slows

Posted on    27 October 2011


The Reserve Bank of India (RBI) raised its key policy rates by 25 basis points (bps) on Tuesday, pressing ahead with its battle against inflation while signalling it will hold from further increases amid concerns about decelerating economic growth and hope that price pressures could begin to ease after December.


The central bank also deregulated savings account rates, the last of the country’s administered rates. The repo rate, at which RBI gives money to banks, was raised to 8.5%, and the reverse repo rate, at which it drains excess liquidity from the system, was increased to 7.5%—a corridor of one percentage point is maintained between the two.


“If the inflation trajectory conforms to projections, further rate hikes may not be warranted,” governor D. Subbarao said.


Inflation remains a cause of concern at close to double-digit levels. In a change of tone, though, from the intense anti-inflation campaign it has been waging since March 2010, the second quarterly review of monetary policy clearly reflected economic worries.

RBI lowered its growth forecast for the current fiscal to 7.6% from 8%, citing a slowing world economy and declining domestic demand, but retained its fiscal year-end inflation forecast at 7%. Inflation slowed slightly to 9.72% in September from 9.78% in August.


Interest rates have been raised 13 times since March last year, including that on Tuesday. This has hurt investment sentiment more than subduing demand-side pressures, RBI said.


“Growth is clearly moderating on account of the cumulative impact of past monetary policy actions as well as some other factors,” RBI said. “Some signs of demand moderation are evident, although the impact is being felt more on the investment side.”


Also See | Policy Snapshot (PDF)


RBI had earlier said slowing growth was an inevitable price to pay when tackling inflation. Higher prices were detrimental to long-term growth prospects, it had said.


The policy document highlighted in detail the upside risks to its inflation projection.


“This suggests RBI is still not fully reassured that the inflation outlook will pan out as expected. By the way, we share the same concern,” said Leif Lybecker Eskesen, chief economist for India and Asean (Association of Southeast Asian Nations) at HSBC Holdings.


If inflation can’t be brought under control, RBI may have to resume raising rates. It had committed to such a pause in its 2010 second quarter policy and avoided a rate increase in its mid-quarter December policy. But it started raising rates again as inflation accelerated. It was also forced to change its year-end inflation projection a fortnight before its annual policy in May.


Subbarao doesn’t expect a repeat.


“We are hoping that the trajectory this time will be more reliable than it happened last time around,” he said after the policy was unveiled.


Some economists said RBI shouldn’t have signalled a pause so explicitly.


“While RBI has said that the likelihood of rate action in December is relatively low, if the expected deceleration in inflation does not play out, risks on further monetary action coupled with deteriorating global prospects and domestic policy issues adds downside risks to our FY12 GDP (gross domestic product) estimate of 7.6%,” said Rohini Malkani, economist at Citibank. “This is reminiscent of 2008, when RBI was possibly the last central bank to keep hiking rates,” she said in a research note.


The policy statement will help remove market uncertainties and allow participants to plan investment decisions, Subbarao said.


“Even when we are concerned about high inflation, we also have to be sensitive to moderating growth,” he said.


RBI has been among the most aggressive of central banks in the region. Several counterparts across Asia and other developing regions have either cut interest rates or taken a breather, as worries about growth spread across the world. In its economic review released on Monday, RBI indicated that it was increasingly aware of momentum slowing.


Bond yields dropped as the market hadn’t been expecting an explicit pause statement by RBI. Yields on the 10-year bond fell 10 bps to 8.7% after the policy announcement.


The benchmark Sensex rose 1.86% to 17,254.86 points on Tuesday, but the banking index, the Bankex, lost 1.2% to close at 10,919.40 points, as investors considered the freeing of savings rates detrimental to larger lenders.


The realization that growth is slowing too sharply because of rate action may be too late, some economists said.


“RBI has been slow in acknowledging and acting on the palpable signs of moderation in growth,” said Rajeev Malik, senior economist at CLSA.


According to RBI, the “larger concern is that even with the visible moderation in growth, inflation has persisted”.


The rate hikes alone are not to be blamed for the “significant slowdown in investment activity”, but there are other factors such as policy and regulatory matters responsible for the slowdown, the governor said, an indication that the government needs to do more to shore up growth.


Chanda Kochhar, managing director and chief executive of ICICI Bank Ltd, said RBI “has signalled a transition in stance by indicating that the likelihood of another hike is low given the likely moderation in inflation going forward... Going forward, the moderation in inflation could provide room for monetary policy to address growth risks”.


The latest rate hike is unlikely to be passed on by bankers. They are yet to pass on the 25 bps hike of 16 September.


“Credit demand is not that strong now. We’ve enough liquidity in our bank and we’d not need more deposits, so a rate hike may not be imminent,” said State Bank of India chairman Pratip Chaudhuri.


 Anup Roy & Dinesh Unnikrishnan

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