RBI risks overshooting rate hikes
RBI did not disappoint the market, which was expecting a 25bps repo rate hike in the mid quarter policy review of the annual monetary policy for 2011-12. Ninety percent of participants polled expected a 25bps rate hike. RBI echoed the market sentiments by stating that inflation as measured by the WPI or Wholesale Price Index remained at elevated levels and much above RBI’s comfort zone. WPI for May 2011 came in at 9.06% levels with manufacturing inflation at 7.3%. Inflation estimates does not factor in the rise in oil prices (Brent crude prices have moved up by almost 25% in this calendar year) as the government is yet to pass on the price rise to the end user. The RBI has guided that the policy remains anti inflationary which is an indication that there is likely to be another 25bps hike in the July quarterly policy review.
The question the market has to ask now is whether the RBI is overshooting rate hikes, especially after having undershot rate hikes from the beginning of the rate hike cycle in early 2010 when inflation was climbing. RBI’s inflation guidance in the policy reviews in October, December, January and March were off the mark by a wide margin and RBI initially took baby steps in hiking policy rates. The annual policy in May was when RBI took its first decisive step in combating inflation when it raised policy rates by 50bps. The latest rate hike of 25bps takes cumulative rate hikes over the last fifteen months to 275bps with 75bps coming in over the last two months. If the RBI hikes rates by 25bps in July as per guidance cumulative rate hikes will go upto 300bps.
The RBI definitely risks overshooting rate hikes especially as the economic environment going forward is not rosy. The global economy is in a sluggish growth stage with US unemployment ruling at higher levels of 9.1% and China’s growth expected to come down to below its ten year average growth rate of 10%. China has lowered its growth forecasts as it fighting inflation which is trending at 5.5% levels, much above the government’s comfort zone. The Eurozone which is facing severe debt problems in Greece, Ireland and Portugal is also expected to face growth issues as indebted countries curb spending to rein in debt. Japan after its natural disaster in March this year is seeing a sharp drop in growth expectations. The expected weakness in global economy is reflected in commodity prices with the Reuters CRB commodities index down 8% from highs seen in this calendar year while bond yields globally are down by around 50bps from highs.
On the domestic front there is deceleration in industrial production with April IIP (Index of Industrial Production) contracting month on month. RBI has acknowledged a slow down in rate sensitive sectors such as the auto sector due to rate hikes and price rises. Credit growth has slowed down to below 21% from 23% levels over the last few months. Liquidity conditions remain tight with banks borrowing from the RBI on a daily basis. Factors driving inflation on the global as well as domestic front are definitely weakening.
RBI made one mistake in not hiking rates early enough to quell rising inflationary pressures and now it should not make a mistake in not taking cognizance of weakening inflationary pressures in its rate hike spree.