25 bps or 50 bps...?

The Reserve Bank of India yesterday released its review of the macroeconomic and monetary developments which serves as a background to the Annual review of Monetary Policy 2009-10 being announced today, April 20^th, 2010. The crucial question is whether the rate hike will be of 25 bps or of 50 bps.

Some of the Key Highlights of the documents which we believe will set the tone of the monetary policy are:

· While recovery in private demand needs to be stronger to reinforce the growth momentum, already elevated headline inflation suggests that the weight of policy balance may have to shift to containing inflation, since high inflation itself will dampen recovery in growth

· In the emerging macroeconomic scenario, monetary policy management in 2010-11 will be dominated by the challenge of moderating inflation and anchoring inflation expectations, while remaining supportive of growth impulses

· Concerns about domestic output growth are now subdued as the recovery is getting more broad-based. This is the result of a rebound in industrial output, better prospects for the Rabi crop and continuing resilience of the services sector

· The fiscal exit, as planned in the Union Budget for 2010-11, would contribute to improving the overall medium-term growth outlook, even as going forward, greater emphasis on quality of fiscal adjustment would be necessary

· Net capital inflows can be expected to increase further during the current year reflecting the prospects of higher growth and larger interest rate differentials between India and the advanced economies. Like other EMEs, however, higher capital inflows could influence asset prices, domestic liquidity conditions and the exchange rate. This will have implications for monetary management

· Going forward, the demand for money may increase with acceleration in recovery and the elevated level of inflation

· The initial inflationary pressure was predominantly conditioned by rising food and fuel prices, reflecting the impact of a deficient monsoon on agricultural output and the increase in international crude prices. In the second half of the year, with persistent supply side pressures, inflation became increasingly generalized

· The inflationary conditions, coupled with the stronger momentum seen in the pace of economic recovery, created the compelling ground for altering the Reserve Bank’s policy focus to anchoring inflation expectations

· Reserve Bank’s Survey of Professional Forecasters suggests (median) growth for 2010-11 at about 8.2 per cent

· Inflation can be expected to moderate over the next few months, from the peak levels seen in recent months. There are, however, upside risks to inflation:

o International commodity prices, particularly oil, have started to increase again. In several commodities, the import option for India to contain domestic inflation is limited, because of higher international prices

o It is important to guard against the risk of hardening of inflation expectations conditioned by near double digit headline WPI inflation.

Analysis:

The trade off between managing inflation expectations and still keeping India on the growth path is costly since the capital markets are moving way beyond the real economy. Still, we do expect a rate hike in the annual review of monetary policy due to a over emphasis by the RBI on the inflation front in the macroeconomic and monetary review document.

The street has already started to factored in a repo and reverse repo rate hike of around 25bps, however the central bank may give a negative surprise by taking this number to around 50bps also.

The way Nifty has behaved over the last 4 trading sessions clearly suggests that markets are factoring in a change in RBI’s stance. Thus we strongly believe that its time in the market to remain cautious and move away from the rate sensitive like banking, infrastructure and real estate and move towards defensives.

Happy Investing...!!!