Inflation sends rates up by 50 bps

RBI raises interest rate,says actual inflation higher than expected; Sensex plunges.

Borrowers who have seen their EMIs rising sharply in recent months will soon have to shell out much more as interest on their home and personal loans. Catching the bankers and markets unawares,the Reserve Bank of India on Tuesday hiked its short-term interest rate by higher-than-expected 50 basis points bps,intensifying its battle against inflation which remains stubbornly close to double digits and a cause for concern.

Suggesting that the RBIs assessment of inflation is far more dire than the market,and its tolerance much less despite the slowdown in growth,the RBI raised the repo rate the rate at which it lends money to banks to 8 per cent from 7.50 per cent. Consequently,the reverse repo rate the rate at which the RBI borrows from banks was also raised by 50 basis points to 7 per cent.With this,the RBIs repo rates were raised another 125 bps in the first quarter of 2011-12. This has raised the key operational policy rate by 475 bps in a span of 15 months since mid-March 2010 one of the sharpest monetary tightening seen across the world. Bankers were expecting only a 25 bps hike on Tuesday.

Listing out reasons for the steep hike in repo rate in his first quarter review of the monetary policy for 2011-12,RBI Governor D Subbarao said: As we indicated in our May 3 Policy Statement,inflation was expected to remain elevated in the first half of 2011-12. Actual inflation so far has been even higher than expected. Inflation continues to be the dominant macroeconomic concern. The headline WPI inflation rate for the first quarter of this fiscal year remained stubbornly close to double digits and inflationary pressures continued to be broad-based.

Sounding pessimistic about the price levels and more hawkish than ever before,the RBI also raised the inflation target for the fiscal end to 7 per cent from 6 per cent. Both the level and the persistence of WPI inflation are a cause for concern. Non-food manufactured product inflation ruled above 7 per cent in the first quarter suggesting that producers,operating at high levels of capacity utilisation,are able to pass on rising commodity input prices and wage costs to consumers, Subbarao said.

Shocked Dalal Street which was expecting only a 25 bps hike was battered by bears who pulled the Sensex down by 353 points to 18,518.22 points. The selling was intense in rate-sensitive sectors like real estate,banking,capital goods and auto companies.

Bankers have already indicated further rise in interest rates. Policy actions since last year and the systemic liquidity conditions have led to an increase in deposit and lending rates. In the first quarter,there have been some signs of moderation in credit growth. Going forward,banks would review the movement in funding costs and effect further increases in lending rates based on the same, said Chanda Kochhar,Managing Director amp; CEO,ICICI Bank.

According to the RBI,demand pressures have remained strong. Non-food manufactured product inflation has been significantly higher than the average rate of 4 per cent over the last six years. Crude oil prices remain volatile and are a major risk factor. The recent increase in domestic administered fuel prices and the minimum support price for certain food items will also keep inflation under pressure, it said.

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The second consideration that shaped Subbaraos latest policy decision is that there are signs that growth is beginning to moderate,particularly in respect of some interest rate sensitive sectors. However,there is no evidence,as yet,of a sharp or broad-based slowdown. Several indicators such as exports and imports,indirect tax collections,corporate sales and earnings and demand for bank credit suggest that demand is moderating,but only gradually, he said.

Although the impact of past monetary policy actions is still getting transmitted,considering the overall growth-inflation scenario,we determined that it is necessary to persevere with the anti-inflationary stance, he justified the higher-than-expected rate hike.