Inflationary concerns

RBI has time and again stressed on its concerns on inflation. In the last policy announcement RBI had anticipated that inflation will come down in a gradual manner. But inflation is still reigning in double digits. For June, WPI increased by 10.6% over last June. Increasingly, it is seen that inflation has become more broad-based and manufacturing as well as fuel price inflation has also been rising. For food articles as well, though the growth rate is moderating, but is still at high levels and is not expected to go down substantially unless new crop comes in the market which would be only towards October. Thus inflationary concerns are quite strong and RBI would like to take some action to tame it.

Economic Growth

Economic activity has continued to grow at a good pace. GDP growth for the last quarter was above 8% and for the next year, the growth rate is expected to be higher than last year. IMF in its last World Economic Outlook (WEO) update has projected a growth rate of more than 9% for India in the current year. In recent months, IIP has moderated but is still growing by double digits and some sectors in IIP are showing very good growth. Monsoon has been good till now implying that agricultural growth will also be good and give a boost to the farm income and rural spending levels. This will support RBI’s decision to raise rates.

Liquidity and interest rates

Liquidity conditions have tightened significantly since the last policy announcement. Since May end, when telecom companies made 3G and Broadband wireless access (BWA) payments to the Govt, liquidity has dried up. Banks have been borrowing on an average above Rs 50,000 cr from RBI from its two repo windows on a daily basis. Short term rates (90 day Commercial paper, 90 day T-Bill, call rates) all have moved up. Long term yields, though had come down by about 50 bps from the levels seen in April, but after the July 2 hike in policy rates have hardened by about 20 bps.

In a short time, Dr D V Subbarao is going to announce the First quarterly review of monetary policy and he likely to increase the policy rates by 25 bps.

Author:Praveen Bajaj

Related posts:

1. RBI Monetary Policy 2010
2. First quarterly review of monetary policy 2010-11
3. RBI Monetary policy January 2011

1. change in the exchange rate over the previous month

2. size of the interest-rate gap between each currency

3. size of inflation gap between each currency

• These impulses can drive exchange rates a long way from their fair or “equilibrium” values leading to losses
• To guard against this, the authors added to their model a measure of how far the exchange rate has shifted from its fair value
• Modifications were made to the model to reflect non-linear link between profits and yield and the likelihood of a crash escalating with a currency becoming dearer
• The trade, based on the model, might well turn out to be profitable but the forgone profit is a small price to pay for avoiding a potentially big loss
• However, the authors stress that their approach was better than the simple one at predicting the direction of exchange rates

Author: Rahul Sonthalia, Analyst, Kredent Group

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2. MARKET RISK DISCLOSURES UNDER IFRS 7
3. Overnight Index Swap 3 – Uses of OIS

Some of the Key Highlights of the documents which we believe will set the tone of the monetary policy are:

Global economy has started exhibiting tentative signs of recovery, but the recovery is, however, widely perceived to remain slow and gradual, with receding but significant downside risks

• The first quarter GDP growth in 2009-10 still points to persistence of slowdown
• Information available on various lead indicators in the second quarter of 2009-10 suggests that because of deficient monsoon, kharif output may be adversely affected
• Deceleration in aggregate demand that was witnessed in the second half of 2008-09 continued during 2009-10. Growth in private consumption demand fell to as low as 1.6 per cent in the first quarter of 2009-10. Investment demand also decelerated further, and the high growth in government consumption demand that was witnessed in the last two quarters of 2008-09 moderated.
• Deficient monsoon and the associated drought like conditions in several parts of the country, and the more recent floods in some other parts, could also dampen rural demand
• External demand continues to be weak. Trade data show that during April-August 2009, merchandise exports and imports declined by 31.0 per cent and 33.4 per cent, respectively, over the corresponding period of the previous yea
• The liquidity conditions remained in surplus on a sustained basis, which was absorbed by the Reserve Bank through reverse repo operations under the Liquidity Adjustment Facility (LAF) and the over night rates hovered around LAF signaling ample liquidity into the system
• The changing inflation environment, however, is being driven by strong escalation in prices of food articles, which have increased by 14.4 per cent (year-on-year) so far. Excluding food items, the WPI inflation remains negative at (-) 3.4 per cent.
• From the stand point of monetary policy, anchoring inflation expectations in the face of sustained high inflation in essential commodities will be a key challenge
• The Reserve Bank’s professional forecasters survey points to downward revision to the growth outlook from 6.5 per cent to 6.0 per cent in 2009-10.
• Emerging inflationary pressures may also persist and escalate further on account of the fading away of the base effect, cost push pressures through wage-price revisions in the face of elevated CPI inflation, challenges in improving the supply situation of essential commodities in the short-run, gradual pressure on global commodity prices along with global recovery, and rising inflation expectations on account of elevated CPI inflation.
• The overall economic outlook is, therefore, a mixture of upside prospects of recovery and downside risks. Managing the trade-off between supporting growth and reining in inflation expectations poses a complex policy challenge.

Summary:

The tradeoff will be costly since the capital markets are moving way beyond the real economy. However, we do not expect a rate hike in the second quarter monetary policy review due to a bleak growth outlook, however the tone in which inflation is presented in this press release by the RBI clearly sets a prelude for a rate hike in the third quarter policy review or even before that.

The way Nifty has behaved over the last 4 trading sessions clearly suggests that markets are factoring in a change in RBI’s stance. Thus we strongly believe that its time in the market to start booking profits and move away from the rate sensitive like banking, infrastructure and real estate.

Author: Rahul Sonthalia, Analyst, Kredent Group

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1. RBI likely to raise rates in todays monetary policy review
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