Hawkish RBI surprises with 25-bps rate hike

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SummaryCPI-inflation targeting suggests more rate hikes in early FY15

The Reserve Bank of India (RBI) on Tuesday surprised the markets by increasing the key repo rate by 25 basis points to 8%. Although headline consumer inflation may have eased, thanks to a substantial drop in prices of vegetables, the central bank is uncomfortable with CPI inflation excluding food and fuel remaining flat while core WPI, it points out, has risen. Moreover, the RBI believes there could be an upside risk to the disinflation ‘glide path’ indicated by the Urjit Patel committee, which sees inflation below 8% by January 2015 and below 6% by January 2016.

The central bank, however, tempered its action with an assurance that rates might not need to be raised further if consumer inflation tapered off. RBI governor Raghuram Rajan’s observation reassured bond markets and yields, which had spiked to 8.8% intra-day, settled at 8.75%. The equity markets, which were rattled by the rate hike, also drew comfort from the dovish comment and recovered most of their losses. The markets were also comforted by the governor’s statement that India was better placed today to deal with an external shock given the current account deficit for FY14 was likely to be lower than 2.5% of GDP and given reserves were healthy.

Rajan reiterated that, if necessary, the dollar repayments of oil marketing companies to the RBI could be settled in rupees to prevent any overhang in the currency market.

The governor observed that while there had been some flight of short-term flows in the last few days, long-term money remained.

While the higher repo rate and the increase in the marginal standing facility (MSF) to 8% will mean a slight increase in the cost of funds for those banks that rely more on wholesale funding, bankers were not immediately sure whether loan and deposit rates would trend up. Arundhati Bhattacharya, chairman, State Bank of India (SBI), pointed out that that transmission will happen only when the cost of funds was affected, adding, however, that there could be a “little bit of a rise” in deposit rates though that might not necessarily be passed on to borrowers.

Aditya Puri, CEO and MD, HDFC Bank said that if the governor’s sense was that inflation would start coming off, “The trend would be not one of rates rising.” Puri added that margins were unlikely to be under pressure.

Chanda Kochhar, CEO and MD, ICICI Bank, noted that the course of rates

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