A positive real return to savers still calls for further rate hike: Sonal Varma
Published: 30 Oct, 2013
The Reserve Bank of India (RBI) has hiked repo rate by 25 bps to 7.75% and reduced MSF rate by 25 bps to 8.75%. The central bank has retained CRR at 4%. It has also increased the liquidity provided through term repos of 7-day and 14-day tenor from 0.25% of NDTL of the banking system to 0.5%.
Commenting on the joint economics and rates/FX strategy views on post RBI policy, Sonal Varma, economist at Nomura Financial Advisory & Securities (India) said, ''A successful tapering of OMC demand is a pre-condition to making the repo the operational rate. In his post-policy press conference, the RBI Governor also mentioned that OMC dollar demand will be gradually tapered keeping in mind the value of the rupee, a credible fiscal consolidation plan and growth prospects. Hence, while the repo is likely to be made the operative rate eventually, the process of full normalisation of monetary policy appears to be a multi-month process.''
''While the recent rise in inflation may have been a catalyst to hike repo rates, an equally important reason is an implicit change in the RBI's monetary policy framework, away from WPI inflation towards CPI inflation. This framework suggests that because of current high CPI inflation, the present repo rate has been persistently below the neutral rate, so recent repo rate hikes are intended to align interest rates to 'real' domestic inflationary conditions. With CPI inflation close to 9.5% and deposit rates in an 8-9% range, a positive real return to savers still calls for a further hike in the repo rate,'' Varma said.
CPI inflation has persisted above 9% for over six years and inflation expectations have remained in double-digits for four years now and are currently rising. Moderation of inflation expectations in a supply-constrained and supply shock-driven economy such as India will be a lengthy process. Apart from the continuous shocks from food price inflation every year, domestic fuel prices remain suppressed and will be a constant source of price pressure. Potential further weakening of the rupee due to QE tapering next year is another possible shock. Hence, reining in inflation expectations will likely be a long, drawn-out process, during which rates will likely remain higher, Varma opined.
Further Varma said, ''We maintain our baseline expectation of another 25bp hike in the repo rates to 8% by March 2014, followed by a prolonged pause. However, the likelihood is increasing that the terminal repo rate in this cycle may have to be higher to lower inflation expectations, moderate CPI inflation and to give a positive real return to savers."
''Even though exports and agriculture growth are likely to be better, both monetary and fiscal policies are turning pro-cyclical, as we had indicated, which is likely to be a drag on domestic demand. In fact, with medium-term rates inching higher and because of the lagged effect of interest rates on the economy, we see downside risks to our real GDP growth forecast of 5.1% y-o-y in FY15,'' she added.
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