Higher rates, same growth: Something doesn't add up

The Reserve Bank of India (RBI) surprised the markets by raising the repo rate by 50 basis points (100 bps make 1 percent) in its policy review on Tuesday.

What makes for depressing reading is the central bank’s end-of-the-fiscal year forecasts, where it has revised the inflation projections as measured by the WPI (Wholesale Prices Index) upwards to 7 percent, up from 6 percent.

GDP growth expectations for 2011-12 stand unrevised at around 8 percent levels while the credit growth target is brought down from 19 percent to 18 percent. The optics of the move implies that the RBI wants to bring down aggregate demand in the country to curb inflationary expectations,

[caption id=“attachment_48867” align=“alignleft” width=“380” caption=“The RBI’s chart shows that inflation will remain at 9 percent plus levels till end of calendar 2011 and then trend downwards to 7 percent. PTI”] [/caption]

However, by not adjusting the GDP growth projection, the RBI seems to be betting that falling aggregate demand will not hurt or bring down inflation significantly.

The big bang rate hike of 50 bps has hit the markets hard. Benchmark stock indices, the Nifty and Sensex, are down by more than 1.5 percent while 10-year benchmark bond yields have gone up by 10 bps.

The markets were expecting a 25 bps hike with an indication of a pause in rate hikes and instead got a 50 bps rate hike with no indication of a pause. The short-term trend of the markets is down, with both equities and bonds suffering a jolt.

In the medium term, the markets will have to assess the course of inflation, the course of the economy and potential moves by the RBI. The RBI’s chart shows that inflation will remain at 9 percent plus levels till end of calendar 2011 and then trend downwards to 7 percent.

The markets will have to question this assumption as the RBI’s forecasts on inflation have been wrong for over the whole of last year. If the RBI can get inflation wrong on the way up, it can get it wrong on the way down, too.

The course of inflation will be charted by economic growth variables. The RBI has forecast GDP growth at 8 percent levels despite rate hikes and higher projected inflation. The RBI itself has pointed out that investment demand is slowing down and it could be a worry down the line.

The rate hike of 50 bps will push banks to raise lending rates and this will work towards bringing down investment demand, which is already trending down.

Weakening trends in the Index of Industrial Production, which is trending at 5.7 percent in the first two months of this fiscal against 7.8 percent growth seen for the whole of 2010-11, will bring down growth expectations sharply. A global slowdown on worries of US unemployment, Chinese inflation and growth fears and eurozone debt will further bring down growth expectations.

The RBI has raised rates cumulatively by 125 bps in the last three months. In this policy review, it has mentioned that inflation remains a pre-dominant concern but there are recognisable threats to growth as well.

The RBI’s next review is in September when the monsoon would have done its course and there will be more data points on the trend of economic growth. It is unlikely that RBI will raise rates further unless there is a real threat to inflation in the form of commodity prices.

The RBI is being unrealistic in projecting steady economic growth and rising inflation expectations amidst a period of monetary tightening. Growth or inflation or both growth and inflation will have to come off.

Growth and inflation will come off as the RBI maintains a tight policy regime despite signs of demand coming off. Inflation coming off is good for bonds but growth coming off will pressure equity markets. However, if there are expectations that the next fiscal will see monetary policy loosening, equity markets will look up.

The author is editor www.investorsareidiots.com **, a financial web site for investors.**