The RBI has bitten the bullet rather gingerly in its busy season credit policy. A hike of 0.25 per cent in the reverse repo and the knock-on effect of that raise is enough to just maintain parity with US rate hikes. Everybody was expecting this and banks had already starting pushing loan rates up in anticipation.
There is a credible economic theory to the effect that central bank action only has the desired effect when it is unexpected and that wasn't the case. Nevertheless, what was the desirable effect from the RBI perspective?
My guess is the RBI just wants to maintain equilibrium in the growth-inflation-rupee trade-off. All it is doing is balancing off higher US rates to ensure that the rupee doesn't go into freefall. The RBI can't be too worried about a BoP crisis given the enormous currency warchest.
Inflation's up and likely to rise further. But there's no sign of overheating at consumer level because competition has made it difficult for producers to pass on rises in input price.
High energy prices are responsible for both the higher inflation and also for the current account deficit. However, overall growth is strong and likely to remain good and a weak rupee could well be a prop for exports.
Naturally the biggest impact of rate changes is on financial assets. A rate hike is usually bad for banks. For one thing, it lowers profits in the short run; the value of a portfolio of loans issued at lower rates declines, as does the price of T-bills and government bonds. This offers tactical justification to sell bank stocks now and look for a buyback early in Q4, 2005-06 after (we hope!) relatively poor Q3 results.
A second point: rate hikes can hit credit demand. This affects lender business volumes. More than industrial credit, the impact will be in retail. The consumer explosion (automobiles, white goods, housing loans, credit card financing, etc) has been driven by debt. A reluctance to take on more debt could hit auto and retail housing since both are driven almost totally by loan availability and costs.
However the bank credit to deposit ratio had been rising steadily and if that trend had continued, banks would have started running out of liquidity soon. In that sense, the hike is not a bad deal.
In real terms, the hikes are just about enough to keep pace with inflation and if there's another spike in crude prices, real interest rates could fall by December-January.
Balancing all this off is difficult for anyone -- even for the central bank with its access to far better information than the average analyst. Net-net, the hike won't make too much of a difference. It won't be enough of a shock to put a dampener on GDP growth, nor is it likely to over-protect the rupee and force a sudden strengthening.
Coming back to banks, there will be a fall in portfolio profits and as mentioned above, this could also mean a fall in stock prices around January when Q3 results will be released.
There may also be a case for exiting debt mutual funds because there could be capital erosion for exactly the same reason. If you exit now and re-enter in January, this would afford protection against capital erosion.
In the meantime, parking the proceeds in short-term deposits could actually work better than more fancy options.