RBI Mid-Sept Monetary Policy Review – Loans to become dearer

The hawkish global economy recovery coupled with high inflationary pressures forced the Central Bank to raise Policy Rates at the pace faster than the market expectations. The Central Bank, RBI in its Mid-Quarter Monetary Policy Review increased the repo rate and reverse repo rate under LAF.


• Repo Rate and Reverse Repo Rate under Liquidity Adjustment Facility (LAF) increased by 25 bps and 50 bps to 6 per cent and 5 per cent respectively, thus, bringing out the LAF rate corridor to 1 per cent.
• Bank Rate and CRR (Cash Reserve Ration) retained at the same level of 6 per cent each

Domestic Scenario
The RBI stressed on that fact that Inflation has become a kind of concern; even the new index of headline inflation as measured by WPI suggests that the monthly average of WPI inflation for Q1 of 2010-11 under the new series at 10.6 per cent was about 50 bps lower than the rate of 11.1 per cent under the old series. Inflation rates have reached its peak and are most likely to remain at the same level for the next few months. However, Food Inflation continues to move northwards and touched 14 per cent in Aug 2010 as per new series.

Another concern that the RBI documented that the negative real interest rates have been affecting deposit growth rates of banks as savers look for higher returns elsewhere. The RBI wanted deposit growth rates to increase as accordingly the bond supply will be a thorough affair in its weekly auctions without any devolvement which may put pressure on yields. The trend suggests that higher deposit growth rate require higher demands for federal bonds as the bank need to maintain the SLR requirement.

The RBI also indicated that higher than expected realizations on 3G and BMA auctions combined with robust tax revenues have virtually eliminated the risk of the fiscal deficit overshooting its target of 5.5 per cent, even after the additional demand for grants from the Central Government have come up in the Parliament. The Water God, Monsoon has revived the growth prospects in Agriculture which will contribute to good rabi harvest.

Liquidity – from a large surplus to deficit
From a surplus mode, the liquidity entered into a deficit mode after the July Policy review, thus, making the repo rate as the operative policy rate. The current hike will prompt many banks to raise the lending and deposit rates which will sustain the strength of the transmission mechanism.

Global Factors
The RBI remained elusive of global circumstances where the slow recovery has halted many advanced economies to hold their rates further for an extended period. This led to massive inflows into developing economies including India. Moreover, the weak global demand coupled with strong domestic demand has increased the trade deficit and the current account deficit has also been widening. However, Europe has demonstrated remarkable resilience; China too bounced back with industrial production and trade numbers reviving sharply. “Overall, even as the global environment continues to be a cause for caution, the big picture has not worsened significantly since July”, said RBI in a press note.

Need for the hike in Policy Rates
Though the hike in policy rates were expected but by increasing the Reverse Repo Rate by 50 bps, higher than the market expectation of 25 bps, the RBI has used this opportunity to reduce the LAF rate corridor, which will reduce the expected volatility in overnight rates. Moreover, it also wanted to reduce the impact of negative real interest rates which led to savers to move to alternate products giving higher returns.