Interest rates set to rise as RBI raises repo, reverse repo rates

Written by fe Bureau | Mumbai | Updated: Jul 28 2010, 07:16am hrs
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Clearly anxious about runaway inflation but convinced that economic recovery is strengthening, RBI on Tuesday turned slightly more hawkish than expected, increasing the repo rate by 25 basis points to 5.75% while raising the reverse repo rate by 50 basis points to 4.5%. A narrower interest rate corridor of 125 bps compared with 150 basis points earlier would help reduce volatility in short-term rates, which is important since banks have to benchmark their lending rate against a base rate now. It would also ensure better transmission of monetary policy.

Its important that the signals that we send are transmitted, which may not have happened so far because liquidity was in a surplus, said RBI governor Duvvuri Subbarao at a press conference after reviewing the monetary policy for the first quarter of 2010-11. As credit demand picks up and liquidity becomes tighter, we expect both deposit and lending rates to go up, the governor added. Subbarao was also unambiguous about the fact that rates needed to be normalised further since they were not consistent with the current macro environment. We have work to do, we havent reached there yet, said Subbarao.

Almost accepting that inflation is unlikely to come off in a hurry, the RBI raised inflation projection for 2010-11 to 6% from 5.5%, admitting that it is worrisome. The balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations, Subbarao said, pointing out that wholesale inflation has been running in double digits for five months now, with chances that the 10.6% number for June could be revised upwards. Subbarao, however, said he was fairly confident that inflation wouldnt cross 6%, though he cautioned that any further increase in prices of petroleum products could have an impact on inflation.

However, the RBI clearly meant business when it said it would actively manage liquidity to ensure that it remains in balance and that excess liquidity does not dilute the effectiveness of policy rate action. Indeed, the central bank doesnt seem to be perturbed that the system is likely to remain in deficit mode for now, its confidence probably stemming from the fact that growth is firmly on its side the GDP target for 2010-11 has been raised by as much as 50 basis points to 8.5%.

Bankers expect liquidity pressures to push up short-term deposit rates and more important, its now possible that rates on loan will be reviewed in the three months to September 2010 before they are increased.

This, they said, was especially true of teaser rates on home loans, which most banks were offering between 8% and 8.25%. OP Bhatt, chairman of SBI, the countrys largest bank, told agencies the pressure on interest rates will rise following the RBI move. Upward bias has definitely built up and now all depend on credit offtake...Every bank will absorb it for now and put it into their calculation. Different banks have different profiles, and at SBI, we will be looking and thinking (at raising rates) over today and tomorrow, he said.

Said Aditya Puri, MD at HDFC Bank: As far as interest rates are concerned, there is an upward bias, though no one can say when they will increase. There will be no immediate increase in interest rates but there will be a rise not too far in the future.

Money may be in short supply, but the bond markets didnt really budge, with the 10year benchmark yield moving up about 5-6 basis points to close at 7.7%. Said Jayesh Mehta, MD & country treasurer, Bank of America: The rate hike has been priced in so the 10-year yield should move in the range of 7.55-7.75 basis points. However, dealers believe the yield curve would flatten somewhat with short term rates likely to move up further.

Governor Subbarao also pointed out that the risk of capital flows could run both ways; should global recovery falter, a widespread spread in global trade could potentially slow down capital flows. On the other hand, central banks in advanced economies were likely to maintain accommodative monetary policies and the strong growth potential of countries like India would see large inflows. Making it abundantly clear that the RBI was on top of the situation, the governor said the RBI would act whenever necessary and announced that it would now meet at intervals of about one and a half months, after every quarterly review.