As per RBI, domestic inflation risks remain high, notwithstanding both signs of moderation in commodity prices and some deceleration in growth. Against this backdrop, RBI has indicated to firmly continue anti-inflationary monetary policy stance, recognizing some short-run deceleration in growth may be unavoidable in bringing inflation under control.

Downside risks to global growth prospects increases

As per the RBI, the global economy weakened in Q2 of 2011. Lead indicators suggest that growth moderated in both advanced economies and emerging market economies (EMEs) under the impact of high oil and other commodity prices, the spillover from the Japanese natural disasters and monetary tightening in EMEs to contain inflationary pressures. Uncertainty about the resolution of the sovereign debt problem in the euro area has increased. These developments increase downside risks to global growth prospects.

International commodity and oil prices showed signs of moderation on weak economic data and unwinding of financial positions. However, on a year-on-year (y-o-y) basis, commodity price inflation is still high. Consequently, headline inflation rose in major advanced economies despite negative output gaps. As inflation in EMEs remained elevated due both to high commodity prices and strong domestic demand, many EMEs persisted with monetary tightening during Q2 of 2011 to contain inflation.

Overall, even as there is deceleration in some important sectors, notably interest-sensitive ones such as automobiles, RBI states that there is no evidence of any sharp or broad-based slowdown. Corporate earnings growth and profit margins in the fourth quarter of 2010-11 were broadly in line with the performance over the past three quarters, suggesting that demand remained steady, and in the face of sharp increases in input costs, pricing power remained intact. Credit grew steadily, while the composite Purchasing Managers' Index (PMI) for May 2011 suggests reasonably good conditions.

The headline WPI inflation rate was 9.7% in March 2011. In April 2011, it was 8.7% and rose to 9.1% in May 2011. The numbers for April and May 2011 are as yet provisional and, given the recent pattern, these numbers are likely to be revised upwards. Thus, the headline WPI inflation rate remains elevated, consistent with the projections made in the Annual Policy Statement of 3 May. The main drivers of WPI inflation in April-May 2011 were non-food primary articles, fuel group and non-food manufactured products. The consumer price inflation for industrial workers (CPI - IW) rose from 8.8% in March 2011 to 9.4% in April 2011.

RBI has expressed concerns over high non-food manufactured products inflation above its medium term trend of 4.0%. Besides reflecting high commodity prices, AS per RBI it also suggests more generalised inflationary pressures; rising wages and costs of service inputs are apparently being passed on by producers along the entire supply chain.

Year-on-year non-food credit growth moderated from 21.3% in March 2011 to 20.6% in early June 2011, but remained above the indicative projection of 19%. The y-o-y deposit growth increased to 18.2% in early June 2011 from 17.0% in March 2011. Consequently, the incremental non-food credit-deposit ratio moderated to 80.5% (y-o-y) in early June 2011 from 95.3% in March 2011. The y-o-y increase in money supply (M3) was at 17.3% in early June 2011 as compared with 16.0% in March 2011.

Monetary transmission improves

Monetary transmission has been quite strong with 45 scheduled commercial banks raising their Base Rates by 25-100 basis points after the May 3 Policy Statement. Cumulatively, 47 banks raised their Base Rates by 150-300 basis points during July 2010-May 2011. The higher cost of credit is restraining credit growth, but it still remains fairly high, suggesting that economic activity is holding course.

Liquidity to remain consistent with anti-inflationary stance

During the current fiscal year so far, liquidity conditions have remained consistent with the anti-inflationary stance of monetary policy. The Government's cash balances moved from a surplus of Rs 89000 crore on an average during Q4 of 2010-11 to a deficit of Rs 29,000 crore during Q1 of 2011-12 (up to 15 June 2011). Consequently, net injection of liquidity through LAF repos declined from an average of Rs 84000 crore during Q4 of 2010-11 to Rs 41000 crore in 2011-12 (up to 15 June 2011). The net liquidity injection by the Reserve Bank was higher at Rs 60000 crore as on 15 June 2011. The Reserve Bank has indicated that it will continue to maintain liquidity conditions such that neither surplus liquidity dilutes the monetary policy stance nor large deficit chokes off fund flows to productive sectors of the economy.

Indranil Pan, Chief Economist, Kotak Mahindra Bank

The bias is towards further rate hikes as the RBI is willing to sacrifice short-term growth to bring inflation under control. However, the quantum and timing of future hikes could be dependent upon the extent to which the current global uncertainties impact domestic growth. This is evident from the change in RBI's expectations from the policy outcome, from the earlier one of "…sustain growth in the medium term by containing inflation" to "mitigate the risks to growth from potentially adverse global developments." Given our expectations of a sticky inflation trajectory and a modest growth slowdown, we expect another two rate hikes of 25 bps each in the next two policy meetings.  

Tushar Poddar, Chief India Economist, Goldman Sachs

We think the statement indicates that the RBI will remain in a tightening mode, despite softer domestic demand data, there is unlikely to be a pause in the near term. We continue to think the RBI will hike policy rates by another 50 bp in the remainder of 2011, with the hikes likely front-loaded, with the likely softer core inflation prints from September onwards preventing the rate hiking cycle going into 2012. We also believe that the RBI will begin cutting rates in 2H2012 on the back of below-potential growth in the remainder of FY12.

Abheek Barua, Chief Economist, HDFC Bank

Those who were looking for signs for some let up in the RBI's hawkishness amidst the slew of  weak growth data flow will most likely be disappointed by today's statement. The RBI met for its first mid-quarter review in FY12 earlier today and hiked its repo rate by 25 bps-a move that was largely priced in by market players. The repo rate now stands at 7.5% and as a result the reverse repo rate and MSF (marginal standing facility) rate now stand at 6.5% and 8.5% respectively. Pipeline pressures from input pass through, a likely diesel price hike and an increase in government controlled price of key food items is likely to take inflation to double-digits by June-August, 2011 and push average inflation for H1FY12 above the RBI's forecast of 9%.This is likely to drive the RBI to hike its repo rate by at least another 50 bps over the remainder of FY12 before it re-assesses the impact of past tightening measures and global headwinds to domestic growth.

Dr. Arun Singh, Senior Economist, Dun & Bradstreet India

In line with D&B expectation, RBI resorted to a 25 basis point hike in the repo rate in its mid-quarter policy review. Persistence of inflation way above the comfort levels and the still incomplete pass through of global fuel prices in the domestic market has been increasing the concerns of sustaining growth in the medium to long term. Moreover, the upward trend in the non-food manufactured products inflation still reflects the prevailing demand side pressures. The RBI is thus, expected to undertake another round of policy rate hike before taking a pause. As a result, going ahead, we anticipate the economic activity, both the investment as well as the demand, to remain subdued.

Jay Shankar, Chief Economist, Religare Capital Markets

Average inflation in FY12 would remain at 8%, while the peak is now unlikely to overshoot 10.5% now (our earlier estimate was 11%), even with a fuel price hike (Indian Brent basket unlikely to hold strong for long; now ~$114). The revisions in provisional monthly inflation numbers are likely to be capped at 30bps from April'12 onwards. Our FY12 GDP growth estimate remains at 8.2%. We believe that the RBI will need to hike rates by 50bps more before pausing. Global commodity prices and the progress of the monsoon remain the key determinants now, besides broader fiscal policy stance.

Rohini Malkani, Economist, Citi Group

Sticky trends in inflation, coupled with the RBI's stance of bringing down inflation at the cost of growth, prompt us to maintain our view of a further 50bps of tightening in 2011, taking the policy rate to 8% by end-2011. Our forecasts factor in WPI at 8% by Mar12 (vs. the RBI's estimate of 6%). We re-iterate that given consumption dynamics and the fact that ~60% of the rise in inflation is commodity led and beyond the RBI's control, the need of the hour is a pick-up in the investment cycle, and productivity enhancements particularly in food processing, warehousing. 

In our opinion, this tug-of-war between growth and inflation will intensify. Nomura's composite leading index for India points to a further slowdown in the coming two quarters (Figure 1). The slowdown that started with industry and weakened investments is feeding into services with moderation in consumer durables. Despite more than 400 bp of effective tightening over a 14-month span, WPI inflation has remained high at 9.1% y-o-y in May compared to 10.5% a year ago, raising the question of why rate hikes have not yet been effective. One reason is that fiscal policy, by raising farm support prices and boosting rural incomes, is offsetting the impact of higher rates. Therefore, there is an asymmetric impact of tight policy, with investment falling while consumption demand is less affected. Additionally, the WPI basket is dominated by commodities and even the RBI's measure of core inflation – non-food manufactured WPI – is a mix of input and output prices. So, unless commodity prices ease, inflation should persist.

Rajrishi Singhal, Head, Policy and Research, Dhanlaxmi Bank

The policy tone indicates that RBI may come through with at least two more rate hikes of 25 bps each before pressing the pause button. This is evident from the central bank's guidance that it will persist with its anti-inflationary stance, especially since it feels that growth has not been adversely affected so far. What's even more ominous is the RBI statement that it feels that the April and May inflation numbers are likely to be higher than what's been announced. The other area of concern is the level of inflation in non-food manufactured goods, which is way above RBI's comfort level of 4%. Keeping all this in mind, it seems another two rate hikes of 25 bps each seems most likely.

Dr. Veena Mishra, Chief Economist, Mahindra Group:

‘With the WPI numbers released on Jun 14th indicating an acceleration in both headline and core (non-manufactured products) year-on -year inflation,  from 8.7% and 6.3% in April to 9.1% and 7.3%, respectively in May, the RBI had no other option but to maintain its anti-inflationary stance and raise its key policy rates today. I do not think it expects inflation to come down in the near future as result. Rather, the aim is to contain inflationary expectations, and hence, the prices that we see perhaps 8 months to a year out from today. That is, in my view, the correct stance. The statement released today also suggests that the RBI is keeping a fairly close watch on the evolving global economic uncertainties, which is re-assuring. Domestic growth has clearly moderated compared to a year ago but this is, in my view, more the result of policy inaction on the part of the government rather than the monetary actions of the RBI. Without further policy reforms, a stable ‘high growth-low inflation' trajectory just will not materialize.'

Devendra Kumar Pant, Director, Fitch Ratings India

25 basis point hike in policy rate was on expected line. Based on monthly trend of non-food manufacturing sector inflation rate, probability of couple of more hikes in rest of the year is high. Although RBI started tightening from March 2010, its transmission to consumer was not immediate. It is now, banks have started increasing their base rate/prime lending rate, which will help in cooling demand and control inflation.

Deven Sangoi, Head Equity, Birla Sun Life Insurance

Despite 425 bps of effective tightening, inflation, as measured by both the wholesale and consumer indices remains elevated at over 9% levels. Inflation is set to remain at elevated levels, going forward, on account of expected hike in fuel prices, rise in MSP of key crops leading to elevated food inflation levels as well as higher core and generalized inflation. While, so far, there is not a great deal of moderation in credit growth and industrial activity, especially in light of the revamped IIP index data, a sustained continuation of monetary transmission into higher lending rates could impact both consumption and investment demand. RBI has cautioned against recent potentially adverse global macroeconomic developments. Global commodity prices still remain the key external risk though some signs of moderation are becoming visible.  Thus, while the Reserve Bank needs to continue with its anti-inflationary stance, the extent of policy action needs to balance the adverse movements in inflation with recent global developments and their likely impact on the domestic growth trajectory. Hence, going forward, RBI's ability to tackle sustained elevated inflation is quite limited – we see a maximum of 25-50 bps further hike in rates likely during this fiscal. However, comprehensive fiscal action on the inflation management front in terms of addressing supply side constraints, is the need of the hour.

Anil Kothuri, Head-Retail Finance, Edelweiss Group

The latest increase of 25 bps in policy rates in the wake of elevated inflation and a moderating growth momentum is along expected lines. This hike will be mirrored by an increase in lending rates for new and existing home loan borrowers. Home buyers will be forced to re-evaluate their plans since they will get 25% lower loan amounts as compared to a year ago owing to rising interest rates.

Sudhakar Shanbhag, Chief Investment Officer, Kotak Mahindra Old Mutual Life Insurance

There has been an effective increase of 425 bps from a low of 3.25% (reverse repo rate) in Q1 of CY10 to the current repo rate of 7.50% (current operative rate). The RBI has chosen inflation control as its main focus at this point of time and will most probably continue on the rate tightening mode until clear signs of inflation control are in sight. Form a debt market perspective the overhang of supply and probable slippages in the fiscal deficit numbers are in consideration as also growth moderation which can impact long term interest rates. If the fiscal deficit numbers can be managed around the budgeted level it can get a surprise to the market but on the back of volatile commodity prices and under provision of subsidies the probability of this surprise is limited at this point of time. A onetime revenue bonanza like FY11 would be required for the same. The equity markets have largely discounted the higher inflation / interest rate environment and lesser growth relative to the previous year. Moderation in earnings for FY12 / FY13 is also being discussed. The market has absorbed a series of negatives and held up well over the last 3-4 months. In the immediate future a good monsoon and FII flows can give a positive trigger to the market. The government focusing back on some of the reforms process can also get interest back in the market. Global uncertainty and continued lack of movement on the development front locally can lead to corrections.

Sanjeev Zarbade, Vice President (Private Client Group Research), Kotak Securities:

The RBI policy statement does not provide any major respite on the future interest rates movements. Among other things, it Indicates that a) Growth remains still strong – meaning that, it is not concerned about growth, b) Pricing power still remains strong and hence, there is inflationary pressure still in the economy, c) The revisions in inflations are high – meaning that, inflation can remain high and d) Fuel price hikes have not yet come – meaning that, once again inflation can be high. These statements indicate that RBI is concerned about inflation and not growth. However, RBI also added that the global growth scenario can have an impact on us – meaning that it can have a negative impact on growth. So, all-in-all, it seems that, the RBI is concerned about inflation and less concerned about growth. All these lead to one conclusion that, it may continue hiking rates in future. So, the upward bias in interest rates remains. From the market's perspective, today's hike is in line with expectations and hence, the market has not reacted violently. However, the fact that RBI is still not concerned about growth, indicates that, interest rate hikes may be larger than expected.

Girish Batra, CMD, NetAmbit

Loans are likely to become more costly, making retail consumers a little uncomfortable. With this step, the government is trying to evade liquidity from the market. For the same, where on one hand, the interest rate of loans is likely to increase; on the other hand, banks are likely to increase their deposit rates. In such a scenario, those investors, who are paying EMIs of loans, have to curtain their expenses from other sectors and put them into servicing their loan EMIs and hence resulting in lesser liquidity in the market. Similarly, with lucrative deposit rates, the RBI is pushing investors to block their money for at least a certain period into the FDs and other deposit schemes, curtailing the liquid money from market.

Amar Ambani, Head - Research (Private Client Group), India Infoline Group

RBI raised the repo rate by 25bps to 7.5%, choosing price stability in the growth-inflation trade off. While some sections thought that the RBI would maintain status quo fearing a growth slowdown, especially following a 50bps hike just a month ago, the majority expected a 25bps hike in rates with latest reported inflation figures at over 9%. China raising rates too added credence to the RBI decision to hike rates further. The reverse repo rate, at 100bps below the repo rate, stands at 6.5%. While these news seem factored in the market pricing, we see pressure building on consumption plays, autos and select banks too. Going forward, we expect another 25bps hike in rates in the coming months.

Outlook

The domestic growth outlook as indicated in the Annual Monetary Statement of May 3 remains unchanged. However, given the high degree of integration with the global economy, recent global macroeconomic developments pose some risks to domestic growth. Domestic inflation remains high and much above the comfort zone of the Reserve Bank. Particularly, non-food manufactured products inflation rose in May 2011 after showing some moderation in April 2011. Domestic fuel prices do not yet reflect the current trends of global prices. Although global commodity prices moderated in recent weeks, it is too early to downgrade this as a risk factor. Monetary transmission has strengthened. The impact of the Reserve Bank's recent monetary policy actions is still unfolding. The challenge of containing inflation and anchoring inflation expectations persists. Thus, while the Reserve Bank needs to continue with its anti-inflationary stance, the extent of policy action needs to balance the adverse movements in inflation with recent global developments and their likely impact on the domestic growth trajectory.