Reserve Bank of India deems rate hikes necessary

The Reserve Bank of India (RBI) hiked the policy repo rate by 25bps to 8.25% at last Friday’s policy meeting, within expectations. The tone and language of the statement, however, was more hawkish than expected.

The central bank believes it is too early to give up on its anti-inflationary stance and persisting with rate hikes is necessary to curb inflation expectations. As such, a 25bps rate hike at the next policy meeting in late-October seems more likely than not at thus juncture and rate hikes thereafter cannot be ruled out.

For now, we maintain our forecast for the repo rate to be raised to 8.50% by Dec-11 and left steady thereafter. Inflation is likely to remain sticky as pressures for greater transmission of crude oil prices to domestic fuel prices is likely to rise (we estimate the gap between local and international prices to still be as large as 20%) and the fiscal position is deteriorating. Thus, interest rates are unlikely to ease in the short-term. Growth is unlikely to be unaffected from the rising rates and inflation.

We see downside risks to our 7.5% GDP forecast for 2011/12 (Apr-Mar), already lower than RBI forecast of 8% (to which it sees downside risks). However, a short-term sacrifice in growth momentum is made necessary by the rising inflation pressure, which in all likelihood, would be even higher than current levels if not for the central bank’s monetary tightening.