First, RBI took babysteps, now is it an overkill?

RBI did not disappoint the market, which was expecting a 25-bps repo rate hike in the mid-quarter policy review of the annual monetary policy for 2011-12. Ninety percent of participants polled expected a 25-bps rate hike.

[caption id=“attachment_26656” align=“alignleft” width=“380” caption=“The central bank has said inflation is at elevated levels and way above its comfort zone. Danish Siddiqui/Reuters”]  [/caption]

RBI echoed the market sentiments by stating that inflation as measured by the Wholesale Price Index (WPI) remained at elevated levels and much above RBI’s comfort zone. WPI for May 2011 came in at 9.06% levels with manufacturing inflation at 7.3%. Inflation estimates do not factor in the rise in oil prices – Brent crude prices have moved up by almost 25% in this calendar year – as the government is yet to pass on the price rise to the end user. The RBI has guided that the policy remains anti-inflationary which is an indication that there is likely to be another 25-bps hike in the July quarterly policy review.

The question the market has to ask now is whether the RBI is overshooting rate hikes, especially after having undershot rate hikes from the beginning of the rate hike cycle in early 2010 when inflation was climbing. RBI’s inflation guidance in the policy reviews in October, December, January and March were off the mark by a wide margin and RBI initially took baby steps in hiking policy rates.

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The annual policy in May was when the RBI took its first decisive step in combating inflation when it raised policy rates by 50 bps. The latest rate hike of 25 bps takes cumulative rate hikes over the last 15 months to 275 bps with 75 bps coming in over the last two months. If the RBI hikes rates by 25 bps in July as per guidance, cumulative rate hikes will go up to 300 bps.

The RBI definitely risks overshooting rate hikes, especially as the economic environment, going forward, is not rosy. The global economy is in a sluggish growth stage, with US unemployment ruling at higher levels of 9.1% and China’s growth expected to come down to below its 10-year average growth rate of 10%. China has lowered its growth forecasts as it fights inflation which is trending at 5.5% levels, much above the government’s comfort zone.

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The Eurozone which is facing severe debt problems in Greece, Ireland and Portugal is also expected to face growth issues as indebted countries curb spending to rein in debt. Japan after its natural disaster in March this year is seeing a sharp drop in growth expectations. The expected weakness in global economy is reflected in commodity prices with the Reuters CRB commodities index down 8% from the highs seen in this calendar year while bond yields globally are down by around 50bps from the earlier highs.

On the domestic front, there is deceleration in industrial production with April Index of Industrial Production (IIP) contracting month on month. The RBI has acknowledged a slowdown in rate sensitive sectors such as the auto sector due to rate hikes and price rises. Credit growth has slowed to below 21% from 23% levels over the last few months. Liquidity conditions remain tight with banks borrowing from the RBI on a daily basis. Factors driving inflation on the global as well as domestic front are definitely weakening.

The RBI made one mistake in not hiking rates early enough to quell rising inflationary pressures and now, it should not make a mistake in not taking cognisance of weakening inflationary pressures in its rate hike spree.

www.arjunparthasarathy.com