Cost of loan likely to increase further as the RBI up the policy rate

Continuing with its calibrated monetary tightening cycle, the RBI today hiked the repo and reverse repo rates by 25bps each. This is a reaction to the high and sticky inflation, which continues to be nearly double the medium-term target of the RBI since Jan ’10. RBI now projects WPI inflation at 8% by end-Mar ’11.

The repo rate – the rate at which banks borrow from the RBI – now stands at 6.75% and the reverse-repo rate – the rate at which banks park money with the RBI – at 5.75%. Today’s rate hike in the policy rates marks the eighth consecutive hike since Feb ’10. Overall, the RBI has hiked repo rate by 200bps, reverse-repo rate by 250bps and CRR by 100bps in the ongoing rate hike cycle. However, the effective rate hike in the operative rate has been 350bps as the operative rate has changed from reverse repo to repo rate due to change in the liquidity situation.

The RBI has increased WPI inflation projection for end-Mar ’11 to 8% from 7% earlier. WPI inflation inched up, to 8.3% in Feb ’11, after softening to 8.2% in Jan ’11. Notably, the RBI has mentioned that non-food manufactured products inflation continues to be Ill above its medium-term trend – it rose sharply, from 4.8% in Jan ’11 to 6.1% in Feb ’11 – indicating that producers are able to pass on higher input prices to consumers.

What next. The food articles inflation has started considerably softening on account of improved supply and the trend is expected to continue on a likely bumper rabi crop, which will hit the market early next month. The main pressure to inflation, going forward, is likely to come from manufactured products. I expect inflation to remain elevated (7% average) in FY12. I expect the RBI to hike policy rates once more by 25bps each in the next monetary policy meeting on 3 May ’11.

Now, the cost of loans is likely to go up further. Clearly, this negative for the Real estate, auto industry and other interest rate sensitive industries. So, guys, be ready to face a high interest rate environment and plan your expenditure accordingly.

India's central bank takes a breather

The RBI has taken a breather after following the aggressive tightening path since beginning-CY10. As headline inflation has started softening, managing liquidity seems to have become the main focus area for the RBI. We expect further tightening in policy rates, in FY12.

Key policy rates remain unchanged. In line with expectations, the RBI left the repo rate (at which banks borrow from the RBI) and the reverse-repo rate (at which banks park money with the RBI) unchanged, as per its mid-quarter monetary policy review today. The cash reserve ratio (CRR) was kept unchanged at 6%.

Break from policy rate hikes. After six consecutive policy rate hikes since Feb ’10, the RBI has taken a breather. The RBI has hiked repo rate by 150bps, reverse-repo rate by 200bps, and CRR by 100bps since beginning-CY10.

Focus on liquidity. In a bid to address the prevailing acute liquidity shortage in the system, the RBI took two major steps – One, it cut the statutory liquidity ratio (SLR) by 1%, to 24% of net demand and time liabilities (NDTL). This, however, has been counter-balanced by reducing the additional liquidity support under the LAF announced on 28 Nov ’10, to 1% of NDTL from 2%. Two, it announced that it would purchase government securities of `480bn within the next month through the open market operation (OMO).

Liquidity to remain tight. Despite RBI’s measures, we do not expect significant improvement in the liquidity situation in the near term. Post mid-Jan ’11, however, the tight liquidity situation may start easing.

RBI retains broad projections. The RBI has kept the FY11 GDP growth projection at 8.5%. As regards inflation, the RBI has indicated possible upside risk to its Mar ’11 target of 5.5% in the face of rising international commodity prices. WPI inflation considerably softened to 7.5% in Nov ’10, the lowest since Jan ’10.

Policy rate outlook. In line with our estimates of softening of both inflation and real growth rates in 2HFY11, we expect the RBI to maintain policy rates at current levels for remaining-FY11. However, RBI’s medium-term focus is likely to remain biased towards tightening. After softening to ~5.5% levels by Mar ’11, we expect inflation to start inching up post May ’11. Hence, we believe key policy rates would be further tightened by another 75bps in FY12e. Transmission of monetary tightening would keep upward bias for both lending and deposit rates