No more hikes?

As expected, the Reserve Bank of India (RBI) has hiked the benchmark reverse repo and repo rates by 25 basis points each, taking them to 6 and 7 per cent, respectively. Many factors would have provoked the step. The Index of Industrial Production for April-May has clocked in over 10 per cent growth year-on-year, with the manufacturing component exceeding 11 per cent. The early indications of corporate profitability in the first quarter are that they will exceed expectations, something to which advance tax collections will testify. And credit growth has stayed very buoyant, on a year-on-year basis. The only significant factor against a rate hike is the yield on 10-year government securities, which is above the 8 per cent mark. However, the interest rate has to be seen against the combination of growth and inflation and, from that perspective, the data were largely in support of a hike.

There is, though, a twist in yesterday's announcement. A clear signal has been sent that this may be the last of a long series of hikes that date back to October 2004. The RBI apparently believes that it has finally found the reverse repo rate that is consistent with its outlook for growth (7.5-8 per cent) and inflation (5-5.5 per cent). Underlying this is the perception that these ranges for the two variables are mutually consistent and sustainable, i.e. they will remain within those ranges in the absence of a significant shock. The announcement does not, of course, commit to a cap of 6 per cent. It merely suggests that, from here on, the change could be either way, as opposed to inevitably upwards. This is as clear a signal from Dr Reddy as there can be that, as long as growth and inflation remain within their respective ranges, no further increases will take place.

However, that is not a very likely outcome. There are threats to stability from the various factors listed above as well as some others. If the current momentum in industry sustains for some more time, it is quite likely that GDP growth forecasts will be ratcheted upwards, taking them out of the RBI's comfort zone, which essentially means heightened inflationary risks. That could well provoke another rate increase in October or January. Beyond the domestic buoyancy, the threat of sky-rocketing oil prices looms ever larger, especially with the escalation of the conflict in Lebanon. It should be recalled that the Iraq conflict took oil prices to levels that they never descended from. Another round of conflict in the region could well do the same. In which case, both growth and inflation numbers may find themselves pushed out of the zones. Of course, they will come out at opposite ends, making the RBI's objective of maintaining stability that much more difficult. Its priority will be to fight inflation and so it will probably increase rates, but that will prove to be even more of a setback as far as growth is concerned. For now, however, all this is in the realm of speculation. As far as the immediate circumstances go, the RBI has done well to both hike the rate and signal to the market that it just might have found the summit.