As a third part of its normalization act the RBI has initiated the process of monetary tightening on Friday by hiking the repo and reverse repo rates by 25 bps each. Earlier the RBI had removed most of the emergency measures introduced after the financial crisis blew out in October 2008 and had withdrawn a significant amount of liquidity from the system in the months of January and February 2010 by hiking the CRR by 75 bps.
The action of the RBI prior to the policy meeting of 20th April has been driven by rising inflation and as per their estimates upward pressure on inflationary expectations due to a pick up of demand driven inflation. The key is whether this hike is likely to have an impact on the performance of stock markets and what impact it will have on economic growth outlook.
As per my observation of the RBI over the last 15 years and the manner in which they have typically reacted, this time the RBI has been very patient and less hawkish than what it has always been. They have waited patiently to see signs of pick up in manufacturing inflation before initiating the tightening process. Usually in its older avatar the RBI was always apologetic about growth and would act on tightening earlier than they should have and loosened much later.
The severe tightening initiated in the mid 1990’s which killed economic growth in the country for a prolonged period of time was reflective of the earlier mindset of RBI. Today the mindset seems to be focused on sustaining strong growth while maintaining inflationary expectations.
The key point is that policy rates are extremely low by any historical standard and the process of normalization itself requires rates to move up by at least 100 basis points. As such this is likely to happen over the next 6 odd months. The yield curve is quite steep today and in case the expected growth in the economy actually fructifies and government revenues move up in line with expectations the pressure on interest rates moving up substantially from the current levels even over a period of the next 12-18 months looks unlikely to me. The 10 year Government bond yields are unlikely to again move up significantly from where they are trading today as the actual headline inflation has either already peaked out in February or is likely to peak out in March. Given the forecast of a normal monsoon as per various domestic and international agencies the food inflation is likely to come off substantially and the overall inflation should fall to a level of 4-5% by the end of 2010.
The liquidity in the system continues to be strong and should remain high at least till September and typically April -September is the lean season for credit off take in India and as such rates will not typically trend up in this period. Bank credit usually declines on an absolute basis in this time period before picking up in October. This will also keep the pressure on interest rates in check.
Although conventional wisdom would indicate a pressure on the stock markets due to the rate move I still maintain that markets are on the path of a strong up move with a target of a NIFTY level of 5600-5700 over the next two months.