Inflation rate in double-digit and much higher than the comfort level gives RBI food for thought, resulted in hike in policy rates by 150 bps, which put the liquidity situation under high stress. Although, further rate hike is not imminent, but inflation would drive the monetary policy further and interest rate expected to remain high.
Headline inflation is always considered as a major vexation for the India’s central bank. Since, inflation was reading in a double-digit figure, it was a challenge for the Reserve Bank of India to fix the inflation problem under the condition of fragile global economic recovery without denting the recovery process. In response to that, RBI revised its policy rates by over 100 bps and now it does seem that the policy action is working (see the figure) but the money supply is still at 20.34 per cent. Both trend line are now acting inversely, and inflation is falling down to 8 per cent. According to VMW Research, inflation is projected at 7.48 per cent for the month of Nov, 2010. It is also evident that in the past three months, schedule commercial banks and non-banking financial companies have started borrowing from the RBI’s window of Liquidity Adjustment Facility (LAF) at the rate of 6.25 per cent. Since, banks are now left with the limited amount of liquidity, they’re again focusing on deposits from customers. Several banks have revised their deposit rates between 50 bps and 150 bps to attract funds, however, going forward, banks will see a narrow interest rate spread, resulted in lower earnings.
Prospect of Liquidity and Interest Rate
By going through the given above graph, should RBI tight its monetary policy further to keep inflation under control, since the 150 bps already become nasty to the banks and consumers? It is good to know that the RBI’s policy is working to quell higher inflation. However further revision in interest rates in the near term (although RBI indicated temporary pause in interest rate hikes) would be inimical for the economy, since India’s core economic strength is its domestic consumption, and the same is already started fading or set to fall. Perhaps, inflation would remain above the comfortable zone of 5 per cent given the fact that the money supply is above 20 per cent, higher commodity prices such as oil, base metals, although food price component of the inflation index is expected to ease-off owing to strong crop output backed by good monsoon rains.
Discomfort levels of inflation and money supply will keep interest rates higher for the next few months. Moreover, to reduce the impact of tight liquidity, RBI has already started the Open Market Operation (OMO) to infuse liquidity by way of purchasing government bonds in exchange of money.