What's next for interest rates after RBI rate hike?

What's next for interest rates after RBI rate hike?

 Analysts and investors had generally expected the Reserve Bank of India (RBI) to wait until a scheduled quarterly review on July 27 to raise rates. It is widely forecast to raise rates by another quarter point at the quarterly review.

Friday's rate increase is the third this year for India, and the second surprise move that was made outside the regular quarterly meeting cycle.

It also underscores the tension between the RBI, which is worried about containing double-digit inflation, and the finance ministry, which is focused on growth, which is forecast to reach 8.5 percent in the fiscal year that ends in March 2011.

Below are questions and answers on the rate policy outlook.

WHAT IS LIKELY TO HAPPEN AT THE RBI'S JULY 27 REVIEW?

The central bank is expected to raise key rates by another 25 basis points (bps), which would take cumulative tightening to 100 basis points since the RBI started raising rates in March.

One-year swap rates saw their biggest jump in 20 months on Monday morning and federal bond yields rose in anticipation of further tightening.

While expectations had been building that the RBI would raise rates by 50 bps, not 25, at its July meeting, Friday's move is seen to all but cement that outcome on a cumulative basis.

The timing of Friday's move caught many watchers off-guard, as they had figured the likelihood of an off-cycle move was dwindling as July 27 drew closer.

Tight liquidity in the financial system due to higher than expected payments for telecoms spectrum, as well as worries about the euro area debt crisis, had also led investors and analysts increasingly to bet against an off-cycle move.

"The RBI is likely to follow with another 25 bps hike in the policy rates in the 27th July policy review," said Gaurav Kapur, senior economist at Royal Bank of Scotland in Mumbai.

"The process of monetary policy normalisation is likely to gain more urgency considering inflation may not ease significantly below 7.5-8 percent in 2010 and growth momentum remains strong," he said.

ARE THE RBI AND FINANCE MINISTRY ON THE SAME PAGE ON POLICY?

Not necessarily. There is tension between New Delhi's focus on growth and the RBI's concerns over inflation.

The government is under intense political pressure over rising prices, however, and a recent move to raise fuel prices prompted the main opposition party to call a nationwide strike on Monday.

The government has said the fuel price increase will add nearly 1 percentage point to Wholesale Price Index (WPI) inflation, which reached 10.16 percent in May.

Finance Minister Pranab Mukherjee said he supported the RBI's latest move on rates but also said he hoped it would be incorporated into the July 27 review.

"Twenty-five basis points is appropriate and welcome. I do hope it will be subsumed in the new policy statement which will be made by RBI in the latter part of the month," he told reporters on Sunday in the eastern city of Kolkata.

Deputy RBI Governor K.C. Chakrabarty, speaking at the same event on Sunday, said the central bank and finance ministry did not always agree on the best course of short-term action.

"That does not mean that the RBI will not act because (its) perspective is different. For RBI, inflation is everything, and for (the) ministry, growth is everything," he said.

"But in the long term, both will converge, because inflation is the greatest enemy for growth. So even if we take anti-inflationary measures, that does not mean we are against growth," he said.

SHOULD THE RBI HOLD MORE FREQUENT REVIEWS OF MONETARY POLICY?

Some think so. The central bank's penchant for off-cycle rate moves adds an element of event risk for investors and businesses that is less of a factor in economies with more frequent central bank policy reviews.

That said, off-cycle moves are nothing new in India. The RBI made several unscheduled rate cuts during the global downturn.

"Like the Fed, 6-8 times a year would be better given the fast-changing economic events," said R. K. Gurumurthy, head of treasury at ING Vysya Bank.

The Fed's rate-setting panel will meet eight times in 2011.

In February, the RBI deputy governor who handles rate policy, Subir Gokarn, said the central bank would use off-cycle moves only under extraordinary circumstances, a statement seen by some at the time as intended to herald increased predictability when it comes to communication with markets.

The following month, however, the RBI made an unscheduled rate increase, kicking off its current cycle of lifting rates.

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