Smart Investor Excl: Inflation pre-empts rate hike

The hike in key rates is in sync with market expectations following a spike in February inflation numbers.

Monthly inflation numbers for February 2011 came in at 8.3%, 50 basis points (bps) higher than consensus expectations. This consolidated Street expectations of an interest rate hike in the mid-term Monetary Policy review with 25 bps being the generally projected hike given the Reserve Bank of India’s (RBI’s) established predilection for calibrated measures of this quantum (intentional, to avoid any impact on growth recovery process). The RBI reciprocated as expected with a 25 bps hike in repo and reverse repo rates of liquidity adjustment facility (LAF) today to 6.75% and 5.75% respectively.

However, consensus opinion is that with inflation becoming generalized and sharply higher non-food article inflation overwriting the moderation in food inflation in the WPI, this calibrated move will be inadequate to rein in the runaway inflation. Predictably, the (more volatile) weekly inflation numbers for the week ended 5 March 2011 spiked to 12.8% year-on-year (y-o-y) compared to 9.5% printed last week.

The RBI has acknowledged as much and has increased the March 2011 wholesale price index (WPI) inflation forecast (end-Jan policy review) by 100 bps to 8%. This incorporates its outlook for upside risks derived from higher international crude and coal prices and the consequent impact on ‘market determined’ petroleum product prices and non-food manufactured products.

The central bank has also highlighted the threat to growth from fuel and commodity inflation, which could impact the investment climate and slow the robust growth trends. It suggested that the 18.6% dip in capital goods production for January 2011 within the IIP (Index of industrial production) was probably indicative of slowing of investment momentum.

However, the RBI reiterated its anti inflationary focus in its review which has prompted economists to forecast additional rate. HDFC Bank Chief Economist Abheek Barua expects a rate hike of 50-75 bps till December 2011, while Dilip Bhat Joint MD Prabhudas Lilladher expects rate hike in the range of 25-75 bps depending on inflation trends.

On the fixed income front, given the relatively more benign liquidity situation (aside from expected pressure from advance tax filings this month) short-term rates could settle around current levels according to Mahendra Jajoo, ED & CIO Fixed income Pramerica Mutual fund. Long-term rate trends are unclear given the inflationary risks from higher fuel prices, he adds, but could stay range bound till some emerges with early Monsoon indicators in June.

The hawkish environment along with hardening inflationary trends dragged the markets. The Sensex ended 1.1% (209 points) lower at 18,150 levels over its previous close with interest rate sensitive stocks (auto, banks and realty) all predictably in the red.

For more features click here.