The Reserve Bank of India (RBI) on Tuesday hiked repo rate – the rate at which banks borrow from the central bank against government bonds – by 25 basis points (bps) from 7.75% to 8%, indicating that interest rates would remain elevated as long as inflation shows no signs of moderating.
The move, announced as part of the third-quarter review of monetary policy on Tuesday effective immediately, surprised most bankers who were expecting a hold on rate-hikes. This, despite RBI governor Raghuram Rajan hinting at a rate hike just a week back when he said inflation was a "destructive disease" that was forcing banks to keep rates higher.
This is Rajan-led RBI's fourth policy review and each time it surprised markets with unexpected rate actions, be it hikes and pauses. The repo rate was left unchanged in the mid-quarter policy review in December as the RBI said it needs more inflation data. Since September 2013 to date, the RBI has hiked repo rate by 75 bps.
Rajan said the "so-called trade-off between inflation and growth is a false trade-off in the long run". Contraction in industrial activity and services was worrisome in spite of robust and (what appears to be) sustainable crop output, he said. But the silver lining was the narrowing trade deficit and current account deficit which is expected to be 2.5% of GDP against 4.8% last fiscal.
The RBI said the biggest risks to the value of rupee was from the consumer price index (CPI) which was close to double-digit levels. The CPI as of December stood elevated at 9.87%; in comparison to the earlier month's 11.16% level, it was lower though.
Meanwhile, post the announcement of rate hike, the rupee gained after three days of continuous slide. The currency ended at 62.51 to the dollar as against Monday's close of 63.10.
But the currency trend looks momentary as most would now look at the two-day US Fed policy meet beginning Wednesday, bank dealers said. Last month, the Fed reduced its liquidity infusion to the markets through its bond-buying programme by $10 billion to $75 billion. It is expected to remain so in the coming meet, bankers said. The rupee would largely look at foreign fund inflows and outflows to seek a direction, they said.
"From an industry perspective, the comforting factor is the forward-looking guidance put forth. While acknowledging that further policy steps will be data-dependent, the RBI categorically mentioned that it does not anticipate further rate hikes at this juncture. Industry body Assocham believes that as disinflationary forces gather pace here on, the RBI will have the room to turn accommodative in H2 FY15," said Rana Kapoor, Assocham president and founder and CEO of YES Bank.
The RBI faces the daunting task of protecting household budgets, especially the poor, from soaring prices as well as reviving consumption and increasing investments. The Urjit Patel panel's recommendations had indicated a "glide path'' of below 8% CPI for January 2015 and 6% for January 2016.
Most bankers are unlikely to hike rates as they feel the RBI would not resort to further steepening of the key rate at least in the near future. "Subsequent policy decisions will now be at a gap of two months," Kapoor said.
"Broad inflation (WPI), excluding food is still sticky (at 6.16%). Given the indication that this is the last hike in the short term, the market is calm," said K Harihar, treasurer at FirstRand.
Most member banks of the Indian Banks' Association, especially public sector banks, were of the opinion that cost of funds would play an important role in deciding future lending rates. As of now, bankers have adopted a wait-and-watch policy for the next few weeks, said a banker after the meeting.
One private banker said interest rates were likely to rise sooner.
Government bonds gained on Tuesday after a five-day losing streak, after the unexpected hike in interest rates by the RBI whose statement traders said signalled a more dovish stance. The benchmark 10-year bond yield rose as much as 13 basis points after the hike before retreating.