RBI ups repo, reverse repo by 25 bps

In an unexpected move, the Reserve Bank of India (RBI), on Friday, raised the repo and reverse repo rates by 25 basis points each. This means that the repo rate, which is the bank's main lending rate, has been hiked from 5.25% to 5.50% and the reverse repo rate, which is the key borrowing rate, has been increased from 3.75% to 4% with immediate effect.

The additional liquidity support to scheduled commercial banks under the LAF to the extent of up to 0.5% of their net demand and time liabilities (NDTL) currently set to expire on July 2, 2010 is now extended up to July 16, 2010.

The RBI explained its dovish step by saying it was a part of the calibrated exit from the expansionary policy.

The rationale

There have been significant macroeconomic developments since the April 2010 Monetary Policy Statement. At the global level, the recovery is strengthening. However, the outlook continues to be clouded by uncertainty in the Euro area.

On the domestic front, the revised growth estimates by the Central Statistical Organisation (CSO) for 2009-10 and for Q4 of 2009-10 suggest that the recovery is consolidating. The manufacturing sector has recorded robust growth in recent months, aided among others, by expanding exports. The strong underlying growth momentum is also evidenced by the sharp upturn in the capital goods sector, acceleration in credit growth and the widening current account deficit. The monsoon situation so far has been decidedly better than during last year holding prospects for good agriculture growth. In its April policy review, the Reserve Bank projected real GDP growth for 2010-11 at 8 per cent with an upside bias. More recent data suggest that the upside bias has largely materialised. The growth projection will be reviewed in the First Quarter Review on July 27, 2010.

The developments on the inflation front, however, raise several concerns. Overall WPI inflation increased to 10.2 in May 2010, up from 9.6 per cent in April 2010. Food price inflation and consumer price inflation remain at elevated levels. There has been some moderation in food price inflation, but the price index of food articles continues to increase. More importantly, the prices of non-food manufactured goods and fuel items have accelerated in recent months. Year-on-year WPI non-food manufacturing products (weight: 52.2 per cent) inflation, which was (-) 0.4 per cent in November 2009 and 5.4 per cent in March 2010, rose further to 6.6 per cent in May 2010. Year-on-year fuel price inflation also surged from (-) 0.8 per cent in November 2009 to 12.7 per cent in March 2010 and further to 13.1 per cent in May 2010. Although entirely justified in terms of long-term fiscal and energy conservation objectives, the recent increase in fuel prices will have an immediate impact of around one percentage point on WPI inflation, with second round effects being felt in the months ahead. Significantly, two-thirds of WPI inflation in May 2010 was contributed by non-food items, suggesting that inflation is now very much generalised and that demand-side pressures are evident.

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