RBI persists with anti-inflationary stance, hikes repo rate by 25 bps to 8.50%


Persisting with its approach of monetary tightening in a bid to rein in inflation, the Reserve Bank of India today increased the repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 8.25 per cent to 8.50 per cent, based on its assessment of the current macroeconomic situation.

Accordingly, the reverse repo rate under the LAF, determined with a spread of 100 basis point below the repo rate, gets calibrated to 7.5 per cent.

Similarly, the marginal standing facility (MSF) rate, determined with a spread of 100 bps above the repo rate, stands adjusted at 9.5 per cent, the RBI said.

The RBI has also decided to deregulate the savings bank deposit interest rate with immediate effect.

RBI Governor D Subbarao said the decisions were informed by two broad considerations - that both inflation and and inflation expectations remained high, broad-based and above the comfort level of the central bank and that growth was clearly moderating on account of the cumulative impact of past monetary policy actions as well as some other factors.


Dr Subbarao said the RBI expected the current inflation levels to persist for two more months.

"There are potential risks of expectations becoming unhinged in the event of a pre-mature change in the policy stance. However, reassuringly, momentum indicators, particularly the de-seasonalised quarter-on-quarter headline and core inflation measures, indicate moderation. This is consistent with the projection that inflation will decline beginning December 2011," he said.

He said that, as inflation begins to decline, there would be growing room for the policy stance to give due consideration to growth risks, within the overall objective of maintaining a low and stable inflation environment.

"While the impact of past monetary actions is still unfolding, based on our growth-inflation dynamics, we considered it necessary to persist with the anti-inflationary stance," he said.


This is the 13th rate hike announced by the RBI during the last 18 months, during which the repo rate has gone up by a total of 375 basis points.
While the impact of these hikes on the inflation rate is yet to be seen, there are fears that they have affected the growth momentum of the economy.
A hike in the repo rate increases the borrowing costs of banks, which, in turn, usually pass on the burden to their customers, for whom all kinds of loans could become costlier. The latest move could also make home, auto, personal and corporate loans costlier.
Headline inflation has remained above 9 per cent levels for the 10th straight month on supply side bottlenecks, high commodity and fuel prices.
Also, food inflation, which accounts for over 14 per cent in headline inflation, stood at a six month high of 10.60 per cent for the week ended October 8.
The Second Quarter Review of Monetary Policy for 2011-12 unveiled by Dr Subbarao spells out three broad contours of the RBI's monetary policy stance:
  • to maintain an interest rate environment that contains inflation and anchors inflation expectations;
  • to stimulate investment activity to support raising the trend growth; and
  • to manage liquidity to ensure that it remains in moderate deficit, consistent with effective monetary transmission.
In its guidance for the period forward, the RBI said it expected the inflation rate to begin falling in December 2011 and then continue down a steady path to 7 per cent by March 2012. It is expected to moderate further in the first half of 2012-13.
"This reflects a combination of commodity price movements and the cumulative impact of monetary tightening. Further, moderating inflation rates are likely to impact expectations favourably. These expected outcomes provide some room for monetary policy to address growth risks in the short run. With this in mind, notwithstanding current rates of inflation persisting till November, the likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted. However, as always, actions will depend on the evolving macroeconomic conditions," it said.
Dr Subbarao emphasised that several factors – structural imbalances in agriculture, infrastructure capacity bottlenecks, distorted administered prices of several key commodities and the pace of fiscal consolidation – combine to keep medium-term inflation risks in the economy high. These risks can only be mitigated by concerted policy actions on several fronts. In the absence of progress on these, over the medium term, the monetary policy stance will have to take into account the risk of inflation surging in response to even a moderate growth recovery, he said.
The RBI said it expected that today's policy action and the guidance it had given would result in the following three outcomes:
  • first, on the basis of a credible commitment to low and stable inflation, medium-term inflation expectations will remain anchored.
  • second, the emerging trajectory of inflation, which is expected to begin to decline in December 2011, will be reinforced.
  • and, finally, it will contribute to stimulating investment activity.
The central bank said that, on the global front, the growth momentum in the United States and the euro area economies had weakened. In the euro area, macroeconomic prospects are intimately tied in to its ability to credibly resolve its sovereign debt and financial sector problems, it said.
The adverse feedback loops among sluggish growth, weak sovereign balance sheets, large exposures of banks to sovereign debt and political compulsions coming in the way of a credible solution have created a crisis of confidence, which is a potential threat to regional and global financial stability, it said.
According to the document, the trade and financial linkages increase the risks of the euro area instability transmitting through to emerging market economies (EMEs), which have already experienced large volatility in their financial markets, particularly their currency markets. 
Significantly, while the prices of many commodities declined over the quarter, crude oil prices remained firm. The impact of this on commodity importing EMEs has been exacerbated by currency depreciation, it said.
Turning to the domestic macroeconomic situation, the RBI said the growth of the Indian economy decelerated to 7.7 per cent in the April-June quarter of 2011-12 from 7.8 per cent in the previous quarter. Industrial growth, as measured by the index of industrial production, decelerated to 5.6 per cent during April-August 2011, down from 8.7 per cent in the corresponding period of last year.
It said growth in the service sector was holding up well, although some moderation was possible here, too, on account of inter-sectoral linkages. 
Based on the normal south-west monsoon and first advance estimates that suggest a record kharif production, agricultural prospects look good. However, investment demand has slackened reflecting slower clearance and execution of projects, concerns about inflation and rising interest rates, it said.
In its May Statement and the July Quarterly Review, the Reserve Bank projected GDP growth of 8.0 per cent for 2011-12. The mid-quarter review of September, however, pointed out that the risk to the growth projection was on the downside.
Based on the current and evolving macroeconomic situation, the RBI has revised downwards the baseline projection of GDP growth for 2011-12 to 7.6 per cent.
The document said inflation continued to be a major macroeconomic concern. "The headline WPI inflation has remained stubbornly high averaging 9.6 per cent during the financial year so far. Inflation has been broad-based, and  driven by all the three major groups, viz., primary articles; fuel and power; and manufactured products," it said.
"As indicated in the First Quarter Review, both the level and persistence of inflation remain a cause for concern. Of larger concern is the fact that even with the visible moderation in growth, inflation has persisted. Reassuringly, there is some comfort coming from de-seasonalised sequential quarterly WPI data which suggest that inflation momentum has turned down.
"Going forward, the inflation path will be shaped by both demand and supply factors.
"First, it will depend on the extent of moderation in aggregate demand. Some signs of demand moderation are evident, although the impact is being felt more on the investment side.
"Second, the behaviour of crude prices will be a crucial factor in shaping the outlook of domestic inflation in the near future. The benefit of a decline in global crude prices in the recent period has been more than offset by the depreciation of the rupee in nominal terms.  Thus, the exchange rate will also have some impact on the behaviour of domestic petroleum prices.
"Third, the inflation outlook will also depend on the supply response in respect of those commodities characterised by  structural imbalances, particularly protein items.
"Finally, there is still an element of suppressed inflation in the economy. Domestic prices of administered petroleum do not reflect the full pass-through of global commodity prices. Prices of coal and a few other commodities do not reflect the current market conditions. As and when price adjustments take place, they will add to inflationary pressures.
"Keeping in view the domestic demand-supply balance, the global trends in commodity prices and the likely demand scenario, the baseline projection for WPI inflation for March 2012 is kept unchanged at 7 per cent.  Elevated inflationary pressures are expected to ease from December 2011, though uncertainties about sudden adverse developments remain," it said.
According to the RBI, the systemic liquidity deficit remained within one per cent of banks’ net demand and time liabilities (NDTL), the comfort zone assessed by the Reserve Bank and consistent with the anti-inflationary stance of monetary policy.
"This year so far, the money supply (M3) and credit growth remain above the indicative trajectories of the Reserve Bank. We expect that monetary aggregates will evolve along the projected trajectory indicated in the First Quarter Review. Accordingly, we have retained the M3  growth projection for 2011-12 at 15.5 per cent and non-food credit growth at 18 per cent," it said.
According to the RBI, the risks to growth and inflation projections are:
  • first, a major downside risk to growth emanates from the global macroeconomic environment;
  • second, despite recent moderation, global commodity prices remain high;
  • third, the Government has announced increased market borrowings, which can potentially crowd out more productive private sector investment; and,
  • fourth, structural imbalances in protein-rich items such as pulses, milk, egg, fish and meat will persist and consequently, food inflation is likely to remain under pressure.
Dr Subbarao said the RBI was fimly of the view that controlling inflation was imperative both for sustaining growth over the medium-term, and for  increasing the potential growth rate. 
"The potential growth rate is not a long term constant; nor is it exogenously determined. It is critically dependent upon policies that create a congenial investment climate and encourage investment activity. 
"The challenge for the Government and the Reserve Bank is to ensure that demand is constrained in the short term to bring inflation down, but at the same time to encourage supply response so as to improve productivity and expand the potential output of the economy in the medium term," he added.
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