Inflation rates are climbing upconstantly, above 10% during the recent months, concurrently resulting in an increasein the pricing power. To anchor the inflationary trends, the Reserve Bank ofIndia (RBI) has increased its key rates for the fourth time in the same year.During the first quarter of 2010-11, RBI increased its repo rates to 5.75%, andthe reverse repo rates to 4.5%. Repo rates are the rates at which RBI lendsmoney, and reverse repo is the rate at which it borrows money from other banks.Reverse repo rates act as a floor, and repo rates; as a ceiling.
When domestic banks are inshort of cash, and overnight call money rates are higher than the repo rate,banks approach RBI for cash. Therefore, lending money under repo rates is aneffective policy tool, as it aids in minimizing rates in the overnight market. Whenliquidity is tight, and banks require cash for a short term, repo rates areuseful. The reverse repo process occurs when money market rates fall below thereverse repo rate. Hence, reverse repo is more effective, when there aresurplus funds with the domestic banks.
Non food items account for 70% ofthe WPI (Wholesale Price Index). Recent increase in fuel and electricity isexpected to further push inflation rates higher in the short term. Raising thereverse repo rates enable RBI to narrow the term for short term loans thusreducing the volatility. RBI aims to keep the liquidity under control, andfurther restrict excess liquidity from diluting the policy rate actions. Thebank also contemplates to increase its frequency of reviewing the monetarypolicy. There would be 8 policy announcements in a year instead of 4. The nextreview is planned during 16th September followed by the one in 2ndNovember.
Economists predict intermittentliquidity tightness in the future, making the repo rates to remain as theoperative policy rate. This implies another 150 bps (basic points) oftightening in the operative policy rates from reverse repo to repo rates overthe past two months. Though the liquidity is tight, RBI has left the CashReserve Ratio (CRR) untouched at 6%. CRR is the compulsory amount of cash;banks have to keep with RBI. This will increase the interest rates charged bybanks, thus putting pressure on the industries.
Some industry players arepessimistic regarding the hike. They believe that the RBI decisions will resultin a rise in the lending rates. They fear that borrowing costs will go up, andhigh borrowing costs will impediment business activities. Hike in lending rateswill add pressure on the loans by banks. The current credit market isexperiencing tightness, and interest hikes might further tighten the cashavailability in the market. While hike in rates are planned for curbinginflationary expectations, it would not immediately limit the same.
RBI is currently attempting abalancing act by managing the inflation and fostering growth rates at the sametime. It believes that narrowing the gap between the repo and the reverse reporates will make pricing easier in the market. One more hike in the rates is onthe cards for RBI with the next review planned for September. Optimistically,it can be expected, the inflation would be under control by then.
References:
1) TheEconomic Times, RBI raises key rates in war against inflation, 28thJuly, 2010.
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4) &sec=article&uinfo=<%=server.URLEncode(2843)%>" target="_blank">http://www.financialexpress.com
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