The current environment of stubbornly high inflation, extremely tight liquidity, slowing domestic growth momentum, risk to fiscal consolidation and deteriorating current account position had made the backdrop to the current monetary policy review one of the most challenging ones.

By hiking the repo and reverse repo rates by 25 basis points each, the RBI has rightly chosen to tread the middle path — neither being excessively hawkish nor mild. The move will also increase the real rates, which are still in negative territory.

We expect inflation to remain high, averaging over 8 per cent in FY11 and a further 7 per cent in FY12. Despite the fact that inflation is not due to excessive monetary expansion, since M3 growth is running close to the RBI's guidance of 17 per cent, the government seems to have left the onus on RBI to tackle it.

Preferred tool

In the last few years it has become a norm to use interest rate hike as preferred tool to control inflation despite the fact that monetary policy can have only a limited impact on structural drivers of inflation, such as supply-demand imbalance for food items, capacity constraints, low agricultural productivity, hike in NREGA wages, etc.

Expecting the RBI to tackle inflation by aggressive tightening can impede the recovery of the investment cycle, thereby creating a worse combination of still-high inflation, no addition of fresh capacities and lower growth.

There is a dire need for the government to tighten fiscal policy and improve the quality of its expenditure along with execution capabilities to address these structural issues. It also needs to abstain from populist measures that have the potential to further boost consumption since, unlike the West, which has huge slack capacities and is trying to promote consumption, India is facing capacity constraints.

Cumulative hikes

Going forward, as central banks are doing in most Asian economies, the RBI will continue to keep an eye on inflation, which is impacting savings and deposit growth in the economy.

We expect the policy stance to remain slightly hawkish to do its bit to curb the spill-over effect of high food prices.

As a result, the RBI is likely to keep liquidity in the deficit mode for at least next 5-6 months and gradually hike repo rate by a cumulative 75-100 basis points over the rest of 2011.

(The author is Chief Investment Officer, Birla Sun Life Insurance.)

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