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RBI seen lifting key interest rates 25 bps on May 3
April, 29th 2011

The Reserve Bank of India, battling surging price pressures, is widely expected to lift key interest rates by 25 basis points when announcing its annual monetary policy on May 3, even as some economists call for a 50 basis point rise.

A quarter-point rise would take the repo rate, at which it lends to banks, to 7% and the reverse repo rate, at which banks park funds with it to 6%, and would be the ninth increase in rates by the Reserve Bank of India since March 2010.

Following a March headline inflation reading of nearly 9%, analysts now expect the RBI to raise rates a total of 75 basis points for the rest of 2011, or 25 basis points more than they anticipated in mid-March, a new Reuters poll found.

India's food price index has been rising, reaching 8.76% year-on-year in the week ended April 16, from 8.74% one week earlier. But this is not changing expectations for a 25 bps rise, just as the RBI made in mid-March.

Possible scenarios for May 3:

RAISES RATES BY 25 BPS:

This is the most likely scenario, with the RBI expected to stick with its favoured gradual policy-tightening approach in order not to undermine economic growth. Weak growth in industrial output would support its case for limiting a rate rise to 25 bps.

Each of the eight times the central bank has raised the repo rate since March 2010, it has done so by quarter points, citing the need to balance inflation and growth.

Several investment banks including UBS and Goldman Sachs have recently lowered their growth forecasts for the current fiscal year to below 8%, compared with government forecasts for 9% growth.

Even if the central bank lifts rates by only 25 basis points, economists expect a hawkish tone in its policy statement.

PROBABILITY: Most Likely

MARKET REACTION: The market has priced in at least a 25 basis point rate hike, though the possibility of a 50 basis points increase has risen following the March inflation data.

If there is a 25 bps increase, bond yields may react immediately by dropping about 5 bps and overnight indexed swap rates may ease by about 10 bps. But yields would soon start hardening on expectations of a prolonged rate hike cycle in the absence of stronger measures.

RAISES RATES BY 50 BPS:

The recent surge in inflation -- plus expectations of further price pressures due to a likely rise in state-set fuel prices -- may prod the central bank to divert from its often-stated "calibrated" approach and take bolder tightening action.

Headline inflation has remained stubbornly elevated and has breached the RBI's own upwardly revised projections, stoking inflation expectations. The central bank may want to show stronger intent in its annual policy statement.

PROBABILITY: Less likely

MARKET REACTION: The market has partly priced in this probability. Bond yields may jump by about 10 basis points and swap rates rise by 10-15 basis points with a sharper rise in front-end rates, flattening the swap curve.

The spread between the 1-year and 5-year overnight indexed swaps (OIS) may narrow to 40 basis points from 46 basis points.

TAKES OTHER TIGHTENING STEPS:

A blanket increase in policy rates may not be able to address sector-specific overheating concerns and the RBI could take proactive measures such as increasing risk weights in loans to sensitive sectors like real estate, housing and capital markets.

Some analysts also expect the RBI to raise the standard provisioning norms across all assets to 0.50% from 0.40%.

However, the probability of further sectoral tightening is quite low, as there is little sign of excessive lending to specific sectors.

PROBABILITY: Least likely

MARKET REACTION: There would not be any impact in the money market but bank shares could be hurt.

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