RBI’s 13th rate hike in 20 months – will it pause & continue OR end & reverse?

RBI - Reserve Bank of IndiaThis Diwali, Reserve Bank of India increased the Repo rate (rate at which RBI lends credit to banks) to 8.5% and Reverse Repo rate (rate at which RBI borrows from banks) to 7.5%, both increased by 25 basis points; and thus in last one and a half year it has increased cumulatively 525 basis points. As usual, its a measure to contain rising inflation, which has persisted in the range of 9.5 % since December 2010. RBI also indicated that it may not go in for another hike in the near future and forecast that annual inflation will ease to 7% by March 2012. The stock market responded with a rally hoping that rate hikes might end here, although slowing economy coupled with a weak rupee in a high inflation situation is nothing to cheer about.

In addition, RBI also announced deregulation of Savings Bank deposit rates. This means banks are now free to determine the interest rates on their savings accounts. Before the deregulation, banks were supposed to give a flat 4% p.a. on savings accounts. This in turn will result in intense competition among banks to attract and retain customers and an inevitable rise in deposit interest rates. Following the deregulation, Yes Bank, SBI and IDBI have already indicated that they will raise their savings deposit rates. This is expected to put additional cost pressures on banks and they are likely to offset the impact of this increase by hiking interest rates on their loan products.

As we noted earlier, many banks refrained from raising their lending rates during the previous rate hike. With SB deposit rates deregulation, this time borrowers might end up paying for the increased interest rates. Short term home loan borrowers can probably increase their loan tenure but long term borrowers will have to pay higher EMI. New borrowers would do well to stay away from fixed rate loans at this point. However, its a boon for folks who want to earn extra income on their savings. With the rupee currently trading at nearly 50 to the dollar, NRIs may send more money home to earn higher interest when savings rates in many American and European banks are at or below 1 percent. It would be a good time for investors to lock into fixed deposits for 3-5 year tenures from banks.

An earlier monetary tightening cycle resulted in repo rate being increased 10 times from October 2005 to July 2008, and by 300 bps. This time around the rate increase is steep but there is hope that it will be shorter than last cycle. RBI has indicated that it would consider easing the monetary policy only if inflation falls below 7%. For EMI paying borrowers, this would mean that relief is at least another 6 months away.