In the run-up to the policy, the Reserve Bank of India has been doing every thing possible to keep the market guessing. For instance, it has cancelled two auctions of dated government paper (slated to raise Rs 10,000 crore) this month.
One way of interpreting the cancellations of the two auctions could be that the Central Bank is not comfortable with the higher yield that the market has been asking for.
In other words, it is not willing to raise the rates in the credit policy later this month. At the same time, it has hiked the yield on 94-day treasury bills to around 5.49 per cent last week -- a clear half a percentage point higher than the cost of overnight money. This would signal short-term rates are poised to go up.
On the face of it, there are good reasons for not tinkering with the rate. For one, the wholesale price index-based inflation rate is under control. Even though it rose to 4.24 per cent during the week ended October 1 from 3.97 per cent a week ago, it is well within the RBI projected range of 5 to 5.5 per cent for fiscal year 2005-06.
It is true the US Federal Reserve has hiked its base rate from 1 per cent in June 2004, to 3.75 per cent through 11 hikes, but there is no direct correlation between the US Fed's approach to interest rates and that of RBI.
After all, the base rate in India never went down to 1 per cent either. Since the fall in rates in India has not been as sharp as that in the US, why should the local rates rise in tandem with the US rates?
The reasons for a reverse repo rate hike are no less strong. The interest rate movement always sizes up the inflation expectations and not the inflation rate per se. The inflation rate can only go up from the present level as the base effect (on account of a very high inflation rate in August last year) has started weaning off.
The global inflation outlook is also changing. The producer price index (PPI) based inflation in the US reached its 15-year high of 6.9 per cent in September. Even in the Euroland, pressure on inflation is building up and the European central bank is gearing for a rate hike in early 2006 after a gap of more than two years. Finally, the rupee is under pressure.
From a level of around 43.20 in July, it fell to 45.40 on Wednesday against the dollar. A weaker rupee will add to the inflation expectations as the cost of import will go up. A rate hike could be a counter measure at a time when the central bank is allowing an over-valued rupee (on the trade weightage basis) to find a new level vis-a-vis the greenback.
A mere hike in the reverse repo rate, however, may not serve the purpose. The signal will be stronger if the RBI combines this with a hike in the bank rate that was last tinkered with in April 2003. At that time there was a 25 basis-points cut in the bank rate to bring down to a three decade low of 6 per cent.
Since then, the reverse repo rate has been hiked twice -- by 25 basis points each -- to 5 per cent narrowing the gap between reverse repo and bank/repo rate from 1.5 per cent to 1 per cent.
In a liquidity surplus situation, the rate at which banks park their surplus liquidity with the RBI is a signal. However, the bank/repo rate or the rate at which RBI infuses liquidity becomes a more potent device when liquidity is under strain.
An estimated outflow on about Rs 35,000 crore (Rs 350 billion) on account of redemption of the India Millennium Deposits in December will abruptly end the banking system's honeymoon with liquidity and, hence, RBI can use the bank rate to signal its policy preference now.
The last two rounds of reverse repo rate hike has helped the central bank maintain stability and now it's time for some action. The rate hike will slightly inconvenience the government as its borrowing cost will go up (it has raised Rs 84,000 crore from the market and another Rs 59,000 crore (Rs 590 billion) to be raised before March-end) but will not derail the growth momentum of the economy.
The market appears to believe there will be a rate hike and bankers have, in any case, started hiking lending rates. Will RBI Governor Y V Reddy lead the market or allow himself to be led by it?