RBI released its first mid-quarter review of monetary policy today and it did not surprise on any front. As expected rates have been raised and LAF corridor has been further shrunk to 100 bps.

Highlights of the mid-quarter review released on September 16, 2010

• Repo Rate hiked by 25 bps to 6%, with immediate effect from 5.75% currently
• Reverse repo rate hiked by 50 bps to 5% with immediate effect from  4.5% currently
• LAF corridor has been again shrunk to 100 bps from 125 bps earlier
• CRR has been kept unchanged at 6%
• RBI has said that inflation appears to have been plateaued and recent policy measures have been impacting demand and inflation
• RBI has observed that real rates must be hiked to aid bank deposit growth

Economic scenario

Economy recorded a growth rate of 8.8% during the first quarter of the current fiscal. This has been the highest quarterly growth rate since the December’2007 quarter.

• Monsoon has been good this year and crop production is expected to be far better than last year. Good monsoon can impact the economy in two ways. On one hand, where good crop will release the pressure on food prices, on the other hand, this would put purchasing power in the hands of rural households and create demand for goods and services which might create an upward pressure on inflation. Nevertheless, good monsoon, for the current year creates good growth prospects for the economy.
• Industrial production has been growing at a good pace in the current year till now. Barring for the month of June, when IIP grew at a meager 5.8%, the index has shown a robust performance for the year till now. Leading indicators for service sector  activity also point to a good growth
• Inflation has been seen moderating over the last few months. Food prices’ index and primary articles’ index both have been moderating. With new series, the index is likely to show a slightly relaxed picture of inflation. But still, inflation is still above the target level of 6% for the March’2010 level and there still remain upward pressure on inflation. RBI, in its press release has observed that, inflationary pressures are still likely to remain at high levels for some months.
• Liquidity conditions remained in surplus level for some time, but again since last week there has been a deficit and banks have been borrowing from the Repo window. As on today, banks have borrowed Rs 51,850 Cr through the LAF facility. Liquidity conditions are expected to remain in the deficit as economy enters the busy second half of the year. With credit off-take expected to pick up, banks would need more funds to conduct their business.

Impact of the moves

• Since March 19, 2010, the Repo rate has been increased by 125 bps to 6%. And since May this year, SCBs have been net borrowers from RBI through its LAF Repo window. Increase in rates will increase the borrowing costs of the SCBs and impact the profitability of banks.
• Shrinking of LAF corridor will reduce the volatility in interest rates. With volatility in interest rates, SCBs get arbitrage opportunities in the money market and LAF. With shrinking corridor, these opportunities would get reduced. This move of RBI is in line with the aim to move to a single policy rate regime consistent with international standards.
• Earlier monetary moves have started showing impact on the moderating inflation. This move will further contain inflation and inflationary expectations which are expected to remain at an elevated level for some more months.
• Both money markets and equity markets had already factored in the rate rise. Post the announcement, equity markets have resumed on the bullish trend and have risen from 5830 just before the policy announcement to just under 5900 by 1 pm. Benchmark 10 year yields have also risen by 5 bps after the announcement.

The tone of RBI’s announcement is still on cautious with respect to inflation. It has kept the doors open for further rate hike with expectation of high inflation in the coming months and good growth prospects. We can expect some more action from RBI in the next quarterly review on November 2.

Author:Praveen Bajaj

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