The 25:50 question: Jury is out on rate hike quantum

The jury is still out on whether Reserve Bank of India (RBI) Governor D Subbarao will stick to the central bank’s calibrated approach or become more aggressive in the bid to tackle the growth-inflation tradeoff.

So, while some analysts are betting on a 25-basis points increase in the key policy rates in Tuesday’s annual policy announcement, there is an equally vocal section which thinks the rise would be 50 basis points, in the backdrop of high inflation on the one hand and concerns on growth momentum on the other.

Rohini Malkani and Anushka Shah of Citigroup Global Markets place the odds at 60:40 for a 25 bps rise. They note the deceleration in investment is coupled with a significant part of the price rise being driven by supply side factors, for which monetary policy tools are inadequate. Hence, they think, it should stop the central bank from a stronger dose. In addition, the effect of past hikes has not been fully passed, as monetary policy transmission happens with a lag.

 

A Standard Chartered Bank research note says, “While we acknowledge that inflation has surprised on the upside, and see a valid case for a 50-bps increase, we believe that growth concerns are likely to keep the central bank in gradual tightening mode. The moderation in growth in the past few months – especially in investment demand – cannot be ignored.”

But, others said there is indeed a strong case for a 50-bps hike. The wholesale price index-based inflation, the biggest challenge for the monetary policy authority in the previous financial year, averaged 9.4 per cent, much higher than RBI’s comfort zone of five per cent. The central bank raised the key policy rates by eight times in 2010-11, by 25 basis points on each occasions, but inflation continued to be stubborn.

WPI inflation was at 8.98 per cent in March 2011, higher by almost 100 basis points than RBI’s expectation. The central bank had revised its March-end inflation projection to eight per cent in March from seven per cent made in January. Economists see high inflation going forward, mainly due to an expected rise in petroleum prices once the state elections are over.

Though there is no unanimity on the extent of rate hike this time, there is a near consensus on a series of rate increases ahead. “We are raising our inflation forecast for FY12 to 7.5 per cent from 6.7 per cent, due to the recent large upside surprise in core prices. Inflation is broad-based, with a majority of inflation categories showing increases greater than 10 per cent y-o-y,” Goldman Sachs said in a research report. The brokerage house now expects RBI to raise policy rates by another 125 bps in 2011, significantly higher than market expectations.

“Given the growing element of structural as well as commodity-related factors determining inflation, the key would be whether the RBI accepts a slightly higher level of inflation in the immediate near term,” said Malkani and Shah. They expect rises of 75-100 basis points for the entire financial year 2011-12.

However, bankers said in the immediate term, a 25-50 bps rate increase is unlikely to hit credit demand in the current financial year. They expect credit demand to remain healthy — in line with the finance ministry’s growth projections of nine per cent. “We have targeted a credit growth of 22 per cent after factoring in the likely rate hikes by the RBI during the course of the current fiscal,” said T M Bhasin, chairman and managing director, Indian Bank.

Bank of Baroda and ICICI Bank have placed their credit growth targets for the current financial year at 24 per cent and 20 per cent, respectively.

Economists at Standard Chartered Bank note that credit to the private sector extended by the banking system generally has a strong correlation with economic activity. They expect credit growth to be around 20 per cent in the current financial year.

The banking industry witnessed robust credit growth in 2010-11, with 21.4 per cent growth over the year as on March 25. RBI had projected credit growth of 20 per cent in the same period.