In the mid-quarter monetary policy review on Thursday, the Reserve Bank of India (RBI) raised the reverse-repo rate by 50 basis points (bps) to five per cent and repo rate by 25 bps to six per cent, effectively narrowing the Liquidity Adjustment Facility (LAF) corridor to 100 bps. The central bank justified the action, owing to a need to contain inflation pressures and normalising policy rates.
Since August, there have been questions if the RBI would become cautious in its tone and measures as external demand had weakened while the wholesale price index (WPI) inflation was no longer rising.
We had, however, repeatedly stressed that the gap between real growth and real (negative) rates was still very high and risked creating imbalances in the economy. We are, therefore, pleased to see that the RBI – in its policy statement published on Thursday – echoed our sentiments. It stressed that negative real interest rate for a prolonged period causes distortions to the economy (by discouraging deposits, for example), and that policy action would aim to address that.
The RBI also noted that, with the current inflation rate hovering significantly above the trend level of 5-5.50 per cent, “...there is, therefore, need for continued policy response to contain inflation and inflationary expectation”. Hence we expect to see the central bank continue to hike rates in the remaining two policy meetings (two 25-bp hikes) this year. Another 50-bp in rate hike would take place next year, in our view. We expect policy actions to be symmetric going forward. That is, the 100-bp spread between repo and reverse repo would persist.
The repo rate would continue to be the effective policy rate for the time being as, in RBI’s opinion, the monetary transmission from policy rates to market rates seems to be working better with overnight rates anchored at the upper end of the LAF corridor. This implies the monetary authorities are comfortable with the prevailing liquidity conditions.
Thursday's actions and the policy statement suggest the RBI is no longer inclined to stay "behind the curve" with respect to its monetary policy stance. Unless external conditions deteriorate sharply in the period ahead, the central bank will remain in a firm tightening mode, in our view. We have noted the RBI's hint toward the end of its policy statement that the role of normalisation as a motivation for further actions is likely to be less important. Instead, current and expected macroeconomic conditions will be more important considerations, going forward.
Our call is that domestic demand and price situation will remain tight enough to keep the central bank in a rate-hike mode in the short term.
The author's comment was incorrectly printed in yesterday's edition of Business Standard. The error is regretted
