India's central bank hiked key interest rates more than expected Tuesday to combat rising prices and raised its growth and inflation forecasts for the year.
The Reserve Bank of India hiked the repo rate — at which the central bank makes short-term loans to commercial banks — by a quarter percentage point to 5.75 percent. It raised the reverse repo rate — the rate at which it borrows from commercial banks — by an unexpected half percentage point to 4.5 percent.
Economists had expected quarter point hikes in both rates. The bank left the cash reserve ratio unchanged at 6.0 percent, as expected.
The bank says economic growth for the year through March 2011 will be 8.5 percent, higher than its April forecast of 8.0 percent, thanks to better than expected industrial production, despite resurgent concerns about the health of the global economy.
It raised its inflation forecast for March 2011 from 5.5 percent to 6.0 percent.
"The dominant concern that has shaped the monetary policy stance in this review is high inflation," Governor D. Subbarao said in his policy statement. "With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation."
Headline inflation, which hit 10.6 percent in June — a number that may well be revised upward — has been in the double digits since February. High prices have become a political issue, with opposition parties staging protests, and policymakers keen to check rising prices.
The bank said nonfood items contributed over 70 percent to headline inflation in June. "Inflation is now very much generalized," the bank said in its policy statement. "Inflation is now being significantly driven by demand side factors," it said.
Last year's drought pushed food prices up precipitously. This year the monsoon rains, which crash across India from June to September, are 14 percent below normal. Government meteorologists are predicting that overall rains will be normal, and the central bank said crop area has increased from last year, promising bigger harvests and lower food prices.
The bank said it is concerned that a faltering global economy could crimp trade, hitting India's manufacturing and service sectors. A bigger worry, however, is that growing risk aversion would keep foreign investors out of India, slowing capital inflows needed to fund the nation's widening current account deficit.
The bank has hiked policy rates by three quarters of a percentage point this year, but still has a way to go before getting back to pre-crisis levels. To stave off the Great Recession, the Reserve Bank of India cut the reverse repo rate by 2.75 percentage points, to 3.25 percent, and the repo rate by 4.25 percentage points, to 4.75 percent.
"It's a thin line which the RBI is making," said Shishir Bajpai, a senior vice president in private wealth management at Mumbai's IIFL Capital. "On one side, the government doesn't want to dilute high GDP growth. On the other, it is very concerned about high inflation."
The bank, he said, came down heavily on inflation and may raise rates further in September if food prices don't ease. But there is only so much monetary policy can do to curtail spiraling prices, which have been driven by rains, global commodities markets and supply side constraints.
"There are parts of inflation that can't be contained," Bajpai said. "There's a lot of supply side problems and huge demand growth. Just increasing the rate — as RBI also knows — won't itself curtail inflation. But it has to do what it can."
The bank said the government's recent decision to partially deregulate oil and gas prices will add one percentage point to headline inflation. Higher minimum payments to farmers will further fuel price rises.
The bank also said that given the rapidly evolving economic situation, it would conduct policy reviews every six weeks, instead of every quarter.
Investors took the news in stride. The benchmark Sensex index ticked up 0.4 percent after the bank's announcement, before settling back to 18,075.7 points, up 0.3 percent in midday trade on the Bombay Stock Exchange.
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