Has RBI rate dilemma ended? 25 bps hike win-win for both markets, banks

The Reserve Bank of India (RBI) chose to go against the experts prediction and boldly decided to make another hike of 25 basis points in policy repo rate during the third bi-monthly monetary policy meet. This is the second consecutive hike, which was seen for the first time in RBI governor Urjit Patel’s leadership at the cbank and under Prime Minister Narendra Modi's reign. The rate hike is seen as a win-win situation for both markets and banks. 

According to SBI, with the latest rate hike RBI has decided to frontload the rate hike cycle. It explains that,  RBI had to choose the timing of rate hike between now and later in the Oct’18 policy. However, RBI decided to walk the talk and the rate hike is a win-win situation for both markets and the banks as inflation is expected to rapidly decelerate to sub-5% in coming months and it would have been difficult for RBI to hike then and convince the markets. 

The MPC members decided a rate hike in policy repo rate with majority of 5 votes against 1 in favour of status quo. 

The decision for rate hike is driven by  increase in Core CPI rather than headline CPI. 

SBI opined, "We have examined the seasonally adjusted series of both headline CPI and Core CPI. After comparing the trend of both the indicator, it gave a mixed performance." 

Dr Soumya Kanti Ghosh, Group Chief Economic Adviser at SBI says, “Even as RBI decided to hike, RBI Governor later indicated in the press interaction that the Central Bank target is headline CPI and Core is only a component of it. It will be interesting to see how RBI will react to headline inflation which is expected to decline in coming months.”

A look at past rate hike cycles throws up an interesting trend about the relation between consecutive rate hikes and inflation. 

Earlier, when WPI used to be the key inflation rate, consecutive rate hikes happened when WPI inflation had expanded significantly, even going to double digits. 

However, if we look at the current key inflation rate which is CPI, it was 5.00% in Jun’18 and is expected to go down in Jul’18 to sub 4.5%. This rate hike then seems cautious as the tone of policy statement also does not convey any urgency about rising inflation. 

Ghosh adds, “We believe, in the coming months the services CPI inflation may cross the Goods CPI inflation. There are a number of reasons why services prices tend to rise more rapidly than goods prices.

“Increases in the demand for services relative to the demand for goods may at times explain some short-run increases in services prices relative to those for goods,” added Ghosh. 

“The increase in service inflation dynamics indicate that the relation between inflation and output gap does not seem sacrosanct in Indian context and hence the arguments of output gap almost closed needs to be validated,” Ghosh said. 

Talking about FEMA guidelines, Ghosh said, “ The decision of taking a comprehensive review of financial market timings will bring uniformity across products and markets.”

Therefore, SBI  rules out a October rate hike and are still holding to no further rate hikes in FY19. The bank’s projection for CPI FY19 is at 4.6% and for FY20 is 4.5%. 

Now policy repo rate stands at 6.50% from previous 6.25%. The last time this trend was witnessed was in 2016 - which means current rate hike is at 2-year high.