The central bank's mid-term review of the 2004-05 annual policy was broadly in line with my expectations. This policy review has been shaped by key development since the May policy, viz the sharp rise in headline inflation. The policy review recognises the role played by international commodity prices, oil prices and excess liquidity in the rise in inflation.
On liquidity, while RBI has noted the fall in quantum, it has also pointed out the still substantial excess liquidity outstanding after taking into account the amount temporarily immobilised under MSS.
On oil prices, the central bank has placed greater emphasis on possible second-round inflation effect of oil prices. This indicates that RBI has assimilated the lessons learnt by major economy central banks during the 70s oil shocks.
While liquidity overhang has been tackled through the MSS tool and the September CRR hike, inflation expectations have been sought to be stabilised by repricing credit in a gradual manner.
This step may not immediately impact the headline inflation and it is likely that the average inflation for FY05 may again exceed RBI's target of 6.5 per cent depending on behaviour of oil prices.
Taking a slightly long-term view, the hike in repo rate, the higher priority accorded to price stability and the explicit commitment to consider further steps should all combine to check inflationary expectations that have been gaining ground.
Although the repo rate hike may not immediately translate into a one-to-one rise in commercial banks' deposit and lending rates, I expect these rates to go up over the next one-two months. This is also in line with strong non-food credit demand relative to deposit growth and RBI's expectations of sustenance of credit growth in the second half of FY05.
Among other measures, the central bank has decided to increase the risk weightage on housing and consumer loans by 25 bps each. This is expected to induce a 'reality check' in the pricing and marketing of retail loans and act as a timely reminder to banks and housing finance companies about the possibility of an erosion in the quality of retail loans.
To balance the need to promote affordable housing, the central bank has hiked the ceiling of direct finance to housing sector that will be treated as priority sector lending.
Coming to the impact in financial markets, bond yields have already risen by 15 bps across the maturity spectrum. I expect the 10-year yield to settle in a 25 bps band around the current levels although the behaviour of oil prices holds the key.
The hike in repo rate as well as the ceiling on NRE deposits are rupee positive. However, the overhang of oil imports will prevent any significant rupee appreciation.
Overall, the policy is well thought out and considered response to the complex challenge of maintaining growth momentum, while reining in inflation expectations in the face of an oil shock. I do not rule out another measured hike in repo rate in two-three months if oil prices do not come down and if the rise is passed on to domestic fuel prices.
