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RBI likely to raise interest rates
September, 16th 2010

The Reserve Bank of India (RBI) is set to raise interest rates for the fifth time this year on Thursday as it looks to tame inflation running well above comfort levels in the fast-growing economy. Most economists expect the central bank to raise both its main policy rates by 25 basis points each.

That would take its repo rate, the rate at which it lends to banks, to 6 per cent and the reverse repo rate, at which it borrows from banks, to 4.75 per cent.

The following are the possible scenarios for the meeting:
25 BPS rise in repo, reverse repo rates
Economic growth is robust with signs of capacity constraints. Price pressures are strong and well above the RBI's comfort zone.
Under such conditions, the central bank will feel it has little choice but to maintain its mantra of using a calibrated approach to returning policy to more normal settings.

In addition, some analysts argue now is a good time to continue normalising rates because inflation is expected to ease further in coming months and that might remove the urgency to keep tightening policy.

Asia's third-biggest economy grew in the March-June quarter by 8.8 per cent over a year earlier, its fastest pace in nearly three years while industrial output rose 13.8 per cent annually in July, the fastest since April.

The wholesale price index (WPI) rose 8.5 per cent in August. The RBI sees it easing to 6 per cent by March.

Raising the rates knowing the widespread view that inflation is cooling could signal the central bank is nearing the end of its current tightening phase.

* Probability: Very Likely

* Market impact: This scenario is largely factored in. Bond yields and swap rates may rise in a knee-jerk reaction on the day, but they would cool longer term as markets gain confidence the central bank's flurry of rate rises has come to an end. A signal that the tightening cycle is nearing its end would be a bullish sign for stocks as well.

Look for a 5-6 basis point rise in the 10-year yield, currently at 7.92 per cent.

The OIS curve could bull-flatten with the longer-end moving down faster than the shorter end. The spread between the one-year and 5-year OIS rate could edge in to around 75 bps from around 77 bps.

25 BPS rise in reverse repo rate and no change in repo rate
RBI Governor Duvvuri Subbarao has said inflation is moderating, which has been backed up by a fall in the headline number below 10 per cent.

That would strengthen the case for less aggressive policy action and thus a narrowing in the gap between the repo and reverse repo rates to 100 basis points from 125 basis points.

The RBI may adopt this stance if it wants to wait and watch the results of policy actions taken so far, especially since data from the United States has suggested a faltering recovery there.

This decision would be perceived as dovish and could fuel expectations cash conditions will not be as tight as earlier expected, moving the effective policy rate from the repo rate back to the reverse repo.

This would also indicate that the central bank wants to protect growth by making a gesture that has little practical impact since raising the reverse repo rate would not affect borrowing costs. At its last review, the central bank raised the reverse repo by 50 bps, double the increase in the repo rate.

* Probability: Possible

* Market impact: The 10-year yield may fall to around 7.85 per cent and the OIS curve may steepen with the one-year falling more than the five-year on hopes of more liquidity and a less hawkish stance. The spread between the one- and five-year OIS may widen to around 95 basis points, while the possibility of further rate hikes keeps the short end of the curve high.

No change in policy rates
The central bank may want to wait and see the effect of its four rate increases since March. There are signs that India's economic growth is slowing down and data has pointed to a faltering recovery in the United States.

So the RBI may want to monitor the domestic and global economy, aware that a widening interest rate differential could invite volatility through capital inflows.

Still, India's economy is growing at a healthy clip and headline inflation remains near double-digits, leaving real interest rates in negative territory.

A pause would not mean the end of rate rises though. Even with a pause, many traders would expect the central bank to raise its rates on Nov. 2 at its mid-term review.

* Probability: Less likely

* Market impact: The yield on the 10-year benchmark bond may fall to 7.70 per cent and the OIS curve could steepen as short-end rates slide. The downside to the long end of the curve will be limited on concerns of future rate hikes. The spread between the 1 and 5 year swap rates may widen to 100 bps.

25 BPS rise in repo rate, 50 bps rise in reverse repo
This would be a very hawkish stance and indicate the central bank is more worried than previously thought about inflation, which is well above the RBI's March target of 6 per cent.

Still, this scenario is highly unlikely. Subbarao has said inflationary pressures are moderating and the decision would depart from his mantra of a "calibrated" approach to policy.

* Probability: Least likely

* Market impact: The yield on the 10-year bond may rise to 8.15 per cent and the OIS curve could bear-flatten, with the short-end moving up faster than the longer-end and the spread between the one- and five-year swap rates could compress to around 65 basis points.

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