India's central bank raised its benchmark rate by 50 basis points on Tuesday to its highest in seven years and hiked the cash reserve ratio, delivering a bigger-than-expected tightening to quell double-digit inflation. The central bank raised the short-term repo rate as expected, but the size of the move, which brought the benchmark to 9.0 percent, surprised markets.
Most economists polled by Reuters had forecast a smaller step after last month's two increases totalling 75 basis points. The Reserve Bank of India also raised the amount of funds banks must keep on deposit with it by 25 basis points to 9.0 percent to absorb surplus cash in the banking system. The increase will take effect on August 30.
"Bringing down inflation from the current high levels and stabilising inflation expectations assumes the highest priority in the stance of monetary policy," the central bank said in its quarterly review.
Analysts, most of whom had expected the reserve ratio to stay unchanged, saw the double-punch as a sign the central bank was ready to accept slower growth as a price for lower inflation, which is holding just below 12 percent. The central bank cut its growth forecast for this fiscal year to around 8.0 percent from 8.0-8.5 percent previously.
It also said it was now aiming to bring inflation down to 7.0 percent by the end of the fiscal year in March 2009, instead of its previous more ambitious goal of around 5.5 percent. The government, concerned rising prices hit the poor hardest, is keen to bring inflation back under control before elections due by May 2009.
The finance ministry called the rate move a signal to banks that credit growth must be moderated to tame demand. "These are big strides taken to cool down the economy by reducing demand pressures," said Indranil Pan, chief economist at Kotak Mahindra Bank.
"Given the recent spate of tightening, the central bank has more or less aligned itself to the curve and it clearly highlights the central bank has moved to an inflation fighting mode and growth is now on the backburner." India's inflation, as measured by wholesale prices, has more than doubled since late February to its highest level since 1995.
It accelerated into double digits after a sharp increase in government-set retail fuel prices in June, prompting the central bank to resume interest rate increases after a pause of more than a year. Indian federal bonds yields rose sharply and the rupee strengthened after the news of the interest rate and reserve ratio rise.
The risk of slowing growth is rising up the agenda of the world's central banks, diverting policy makers away from a battle to prevent food and fuel costs from spilling into wages and other prices. Expectations of rate rises this year have faded across much of the industrialised world including the United States and Japan.
In China, which like India raised subsidised fuel prices last month, financial markets scaled back expectations for the pace of yuan appreciation and interest rate increases after the ruling Communist Party and the central bank flagged a policy shift. But India's central bank has been criticised in the past for not acting quickly enough to counter mounting price pressures.
Analysts said Tuesday's move would buy it some time to assess the results of its recent steps. They were divided, however, on whether and when the central bank would tighten policy again. The central bank left the reverse repo rate at which it absorbs excess cash from banks and the bank rate, used by banks to price long-term loans, steady. Both remain at 6.0 percent.
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