Now, get ready for a hike in interest rates

It is time to get ready for a further hike in interest rates. Following the steep hike of 50 basis points each in the repo rate and cash reserve ratio by the Reserve Bank of India (RBI) on Tuesday to check runaway inflation, bankers and money market players are unanimous that interest rates will now flare up by as much as 50 basis points immediately. Banks are already readying to implement such hikes within the next few days.

?Keeping in view the inflation numbers being so high, it was expected that the RBI would take this step. For my bank, an additional sum of Rs 650 crore will be mopped up. There will be a lot of pressure on the bank?s margins. Hence, we will take a call on our lending and deposit rates. Our ALCO is meeting later this week to decide on the revision of rates. I do not expect any further measures to be taken by the RBI to contain inflation in the near future,? said Bank of Baroda chairman MD Mallya.

?There will be pressure on my bank?s margins. We will have to revise our PLR. Our board will be meeting later this week to decide on the same. Going forward, we do not see further measures by the RBI,? said TS Narayansami, chairman and managing director with Bank of India.

However, there are some who feel this is not the end of rate hikes. ?The central bank has given a very strong dose by hiking both the CRR and the repo rate in order to curb inflationary pressures. This will now force banks to review PLRs. We expect lending rates to go up by 50 bps. However, in future, there will be more hikes, if inflation is still a concern,? said DK Joshi, principal economist with Crisil.

?This is a correct step taken by RBI to combat high inflation. With CRR and repo rate hike there will be a lot of pressure on money markets. Bond yields will further harden and liquidity will be tightened further. Cost of credit will go up further. Call rates will also tighten. We expect bond yields to touch 8.80% on Wednesday. It may also touch 9% in future,? said NS Venkatesh, MD & CEO at IDBI Gilts.

RBI said the urgency of ?this broader, albeit somewhat painful but timely contraction? has to be viewed in the context of the new reality of high and volatile energy prices not necessarily being a temporary phenomenon any longer. Monetary policy recognises the need to smoothen and enable this adjustment so that inflation expectations are contained, RBI said.

The Reserve Bank said it has been acting pre-emptively from April 2008 onwards, keeping in view the lagged effects of such measures on the economy. Accordingly, the cash reserve ratio (CRR) was raised by 25 basis points each from the fortnights beginning April 26, May 10 and May 24, 2008. On May 30, 2008 special market operations were announced to alleviate the binding financing constraints faced by public oil companies in importing POL as also to minimise the potential adverse consequences for financial markets in which these oil companies are important participants. Subsequent to the announcement of the oil price hike, the repo rate was increased by 25 basis points on June 11, 2008.

This calibrated approach on an ongoing basis and in a timely manner draws upon the lessons from managing these challenges in the recent period. Graduated monetary policy actions undertaken since September 2004 to withdraw monetary accommodation have successfully moderated signs of overheating that emerged in 2006-07 and continue to have some stabilising influence on the economy. Supply management strategies undertaken by the Government of India are also working through the economy.

However, on a year-on-year basis, money supply (M 3 ) increased by 21.4% as on June 6, 2008 over and above the growth of 21% a year ago and well above the indicative projection of 16.5-17% set for 2008-09 in RBI?s Annual Policy statement of April 2008. Similarly, reserve money increased by 28.5% on June 13, 2008 as compared with 24.6 per cent a year ago. Aggregate deposits rose by 23.2% on a year-on-year basis on June 6, 2008, which is above the indicative projection of 17.0% for 2008-09. Non-food credit growth was 26.2% and was also above the indicative projection of 20%.

At this juncture, the overriding priority for monetary policy is to eschew any further intensification of inflationary pressures and to firmly anchor inflation expectations, RBI said.

However, the central bank said several positive factors that currently exist need to be recognised. Relative to several other emerging economies, the Indian economy has, by and large, a reasonable supply-demand balance which provides some insulation in managing this unprecedented shock from global oil markets. Domestic financial markets and institutions have been largely secured against the contagion from the unsettled conditions in international financial markets.