Case for a 50 basis points on May 3??

Posted: 01 May 2011 05:51 AM PDT

"Sakhi saiyan to khub hi kamat hai…..mehngai daayan maare jaat hai…." goes a number from a popular bollywood flick and rightly so atleast for RBI.

Since the last 15 months or so…RBI has been trying to battle the rising inflation by raising rates (What are policy rates?) eight times since March last year. However inflation, now it seems, is getting out of RBI's control. Over the last one year, there have been many a concerns over structural bottlenecks in the economy which have been causing inflation. Well this might be true, I am not arguing against that. But even if Government decisively acts against structural cause of inflation, it would be some time before anything (like improving storage warehouses, improving transportation facilities, improving public distribution system etc) can be done and it impacts the mighty inflation.

The onus thus totally has been on RBI to manage or rather control inflation. Governor Dr Subbarao is trying to get atleast his inflation forecast right by constantly revising the inflation expectations upwards in all the subsequent policy reviews rather than taking aggressive steps to curb the price rise. Till now RBI has been taking baby steps by raising 25 bps almost every 45 days. The same has had an impact on inflation but only marginally so.

Inflation going forward

As per the last release, WPI for March' 2011 rose to 8.98%, shying away from the 9% mark. Going ahead, I expect price pressure to see more upside post elections due to long pending diesel price hike. Good monsoon forecast by IMD may cool down the expectations but it would be some time before which the same may actually impact the primary articles price. Going by last year's experience, even good monsoons might not have any impact on the prices.

Compromising growth

Growth, which is a trade off for higher interest rates, has been moderating. Latest GDP showed slight moderation in the last quarter's growth rate. It is still some time before we get the first quarter's growth rate. IIP numbers have also been moderating. Inspite of this moderation, I feel there is still some room for RBI to compromise on growth front. As i said in my last post on the same topic (Monetary Policy January), rates are still way below the highs observed during last growth phase before Lehman Brothers fiasco and another 100 bps on repo would not put the economy in any sort of trouble.

RBI clearly has two choices, either to let inflation chop off a few points from the growth rate or to itself step on the growth temporarily and try to tighten its grip on inflation. At the same time, it seems there has been some lag in the transmission of tight monetary policy to the commercial banks. Deposit rates and credit rates to general public have not been impacted to a large extent. Cheap home loan rates existed till recently. SBI put an end to its teaser loan rates only in the last week upon pressure from RBI.

Expectations and impact on equity markets

Thus in the coming monetary policy announcement on May 3, I would expect Mr Subbarao to come down heavily on inflation by going for a more aggressive 50 bps hike in repo rates and take steps to induce commercial banks to raise deposit and lending rates.

If both these factors are accepted by RBI, markets would be looking for some more downside even after a 135 points fall since April 21. Banking stocks would obviously be worst impacted who would be forced to raise atleast the rates and sacrifice their margins.

Author:Praveen Bajaj

Igniting Intellect

May 1, 2011