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| Markets have discounted rate hikes |
| Nilesh Shah / Apr 20, 2010, 00:56 IST |
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The annual monetary policy to be presented by the Reserve Bank of India (RBI) governor on Tuesday will once again test the central bank's expertise in playing the juggling game in a challenging environment. The issues and challenges before it are manifold.
Things have changed post-Budget for the apex bank in terms of managing the monetary policy. In March 2010, foreign institutional investors (FIIs) invested $8 billion in the markets and the resultant increase in foreign flows have strengthened the currency. The RBI seems to be biased towards a stronger rupee as it helps in managing inflation. Inflation numbers may be below expectations but they are still at an elevated level and are hovering around 10 per cent. The RBI is expected to increase the repo rate by 25 basis points this time, too. What is worrying is that, in the last interest rate cycle, low levels were seen in 2003-04 when interest rates, or reverse repo and repo rates, were in the corridor of 4.5 to 6 per cent. This is down to 3.5 to 5 per cent now. This is the case when 10-year yields are above 8 per cent and overall interest rates are rising. A lower repo-reverse repo rate corridor in a rising interest rate cycle is a discrepancy and the RBI will surely try to realign these rates by further increasing them. While market rates are much above the RBI corridor of repo rates, it implies that the market has discounted many more rate hikes in the coming quarters.
The RBI’s real dilemmas are managing inflation without affecting growth, smooth completion of the government's borrowing programme and ensuring orderly movement of the currency. If rates are raised, they can also attract more foreign money as the interest differential moves upward and the vicious cycle turns on even as higher inflows increase liquidity in the system when inflation is high, and so on. Apart from ground level management of the monetary policy, the RBI will also have to manage the perception. In my opinion, the apex bank should comfort the market that it will manage these conflicting objectives in a reasonable manner, so that the inflation pressure is contained and growth is not compromised. Basically, RBI will have to juggle the balls and deal with the hot ball on a priority. It will have to keep juggling as it did in the past. The markets will also have to read the policy signals against this background. The fixed income market has already discounted a repo rate increase by 25 basis points and the cash reserve ratio (CRR) by another 25 basis points. So, yields will be driven by size and the pace of the government’s market borrowing programme.
The equity market is keenly watching how inflation is managed and will wait for a signal that the RBI is fully seized with the priorities of inflation and growth.
(The author is Deputy CEO, ICICI Prudential AMC)
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