RBI's hawkish stance suggests tightening isn't over

Narrowing access to overnight borrowing from central bank to raise borrowing costs of banks by 10 bps

The spectre of higher interest rates is back to haunt the markets. Though the Reserve Bank of India (RBI) has left key rates untouched, its policy stance remains hawkish. The first bi-monthly monetary policy statement for FY15 hasn’t painted a rosy picture for the economy. For starters, growth isn’t expected to pick up meaningfully from the current sub-five per cent levels, which effectively means the current process of disinflation will continue. The policy statement says: “Contingent upon the desired inflation outcome, real gross domestic product (GDP) growth is projected to pick up from a little below five per cent in 2013-14 to a range of five to six per cent in 2014-15, albeit with downside risks to the central estimate of 5.5 per cent.” None of the lead indicators seems to suggest a pick-up.

The policy statement has highlighted several upside risks to inflation, which has moderated over the past few months. Although consumer prices have declined to eight per cent in February, the battle has not been won against prices. The outlook on the Southwest monsoon also appears uncertain, the central bank highlighted. Food prices could rise meaningfully if risks of El Niño play out or commodity prices edge higher globally. India has benefited from benign commodity prices through 2013. Excluding food and fuel, core inflation has remained elevated, implying latent demand pressures. Although RBI’s forward guidance rules out further tightening in the near term, economists are focusing on “upside risks” to inflation highlighted in the policy statement. The current level of inflation (8.1 per cent) is at risk from weather changes, uncertainty on administered prices, fiscal conditions and movement of commodity prices. Nomura’s chief economist Sonal Varma says: “While RBI may remain on hold in the near term, it remains cognizant of the potential upside risks to inflation.”

Consensus seems to be building around further tightening. By curbing access to the overnight borrowing window, RBI has increased borrowing costs by 10 basis points. The central bank has increased access to seven-day and 14-day term repos to 0.75 per cent of deposit base, from the earlier 0.5 per cent. By holding everything else, the move constitutes a 10-basis point increase in effective cost of borrowing funds from RBI, explain Taimur Baig and Kaushik Das of Deutsche Bank. “With the term market clearing well above the repo rate lately, the effective policy rate seems set to remain at least 25 basis points above the policy repo rate for the time being.”

Clearly, the tightening cycle isn’t over yet. Given most of the decline in inflation has been driven by the sharp fall in food prices, the risks of a reversal remain high if the fears of El Niño play out. Leif Eskesen, chief economist for India and Asean at HSBC, says: “RBI saw numerous sources of upside risks to inflation. It sounded a hawkish stance but signalled it would remain on hold in the near-term. However, we do not necessarily think this is the end of the tightening cycle.”