JP Morgan Chase The Reserve Bank of India (RBI) under governor Reddy has proved to be more proactive than market expectations. Indeed, this is the second time that the central bank has raised rates, despite clear suggestions from the government to keep interest rates stable.
By unexpectedly raising the reverse repo rate by 25 basis points, the RBI has convinced markets of its confidence in the ongoing economic revival- the RBI forecasts GDP growth for FY2005-06 at 7.0 per cent, in line with our expectations.
More importantly, the RBI has plainly conveyed its resolve to containing demand-led inflation. The RBI could have taken advantage of the recent moderation in WPI inflation to postpone a rate hike until after the progress of the monsoon was better known.
Also, the RBI could have waited for current concerns over global economic growth to clear. By choosing not to exercise the flexibility it had, the RBI clearly indicates that is not too concerned about the risks to domestic economic expansion from these outcomes.
We expected a 50bp hike in October under the old schedule of policy statements. However, in light of the more frequent review of monetary policy, we now expect the RBI to hike the reverse repo rate by 25bp in July and in October, pushing the policy rate to 5.5 per cent by December 2005.
It is evident that the RBI action will materially worsen the outlook for interest rates.
Bond yields are likely to rise further, and the yield curve will steepen. Banks will continue to eschew incremental investments in government bonds, while a substantial amount of the government's borrowing plan is yet to be conducted.
In the current financial year, 10-year bond yields are likely to climb towards 8.0 per cent as a result, although the RBI's hawkish stance will soften long-term inflationary expectations.
The shift to more frequent policy reviews must be applauded. The move will not only offer the central bank "the flexibility to take specific measures as the evolving circumstances warrant", but, as the RBI Governor pointed out to the press, this is a step towards adopting global best practices in central banking.
More frequent communication with markets will go a long way towards enhancing transparency in the policy-making process .
