RBI rate hike will bring down inflation and growth
The RBI surprised markets by raising the repo rate by 50bps in its policy review today. The end of fiscal year forecasts does not really give comfort on RBI’s reading of the economy. Inflation as measured by the WPI (Wholesale Price Index) is expected to end the fiscal year 2011-12 at 7% which is revised upwards from 6%. GDP growth expectations for 2011-12 is unrevised at around 8% levels while credit growth target is brought down by 1% from 19% to 18%. The optics of the move implies that RBI wants to being down aggregate demand in the country to curb inflation expectations, However falling aggregate demand will not hurt GDP growth nor will it bring down inflation as per the RBI.
The big bang rate hike of 50bps has hit the markets hard. Benchmark stock indices, the Nifty and Sensex are down by more than 1.5% while ten year benchmark bond yields have gone up by 10bps. The markets were expecting a 25bps hike with an indication of a pause in rate hikes and instead got a 50bps rate hike with no indication of a pause. The short term trend of the markets is down with both equities and bonds suffering from the jolt.
In the medium term the markets will have to assess the course of inflation, the course of the economy and potential moves by the RBI. The RBI’s chart of inflation is that inflation will remain at 9% plus levels till end of calendar year 2011 and then trend down towards 7%. The markets will have to question this assumption as the RBI forecasts on inflation have been wrong for over the full of last year. If the RBI can get inflation wrong on the way up it can get in wrong on the way down.
The course of inflation will be charted by economic growth variables. RBI has forecast GDP growth at 8% levels despite rate hikes and rising inflation. The RBI itself has pointed out that investment demand is slowing down and it could be a worry down the line. The rate hike of 50bps will push banks to raise lending rates and this will work towards bringing down investment demand, which is already trending down. A slew of weakening trends in the IIP (Index of Industrial Production) which is trending at 5.7% growth levels in the first two months of this fiscal against 7.8% growth seen for the full year of 2010-11 will bring down growth expectations sharply. A global slowdown on worries of US unemployment, China inflation and growth fears and Eurozone debt will further bring down growth expectations.
The RBI has raised rates cumulatively by 125bps in the last three months. In this policy review it has mentioned that inflation remains a pre dominant concern but there are recognizable threats to growth as well. The RBI’s next review is in September when the monsoon would have done its course and there will be more data points on the trend of economic growth. It is unlikely that RBI will raise rates further unless there is a real threat to inflation in the form of commodity prices.
The RBI is being unrealistic in projecting steady economic growth and rising inflation expectations amidst a period of monetary tightening. Growth or inflation or both growth and inflation will have to come off.
Growth and inflation will come off as RBI maintains a tight policy regime despite signs of demand coming off. Inflation coming off is good for bonds but growth coming off will pressurize equity markets. However, if there are expectations that the next fiscal will see monetary policy loosening, equity markets will look up.