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India central bank makes aggressive hike to fight inflation

MUMBAI - India's central bank raised its key lending rate to its highest in six years on Tuesday and hiked banks' reserve requirements in an aggressive step to combat 11 percent inflation, and signaled it would act again if needed.

The central bank said it wanted to reduce overall demand pressures to stop any instability developing in the buoyant economy due to inflation and said higher energy prices were no longer a temporary phenomenon.

Analysts said government bond yields were likely to jump sharply on Wednesday and stocks fall, as the rate decision, which came after market hours, was above expectations, although traders had been expecting a policy tightening soon.

The Reserve Bank of India (RBI) raised its key lending rate by 50 basis points to 8.5 percent with immediate effect, its highest since March 2002 and the second hike this month.

It also increased its cash reserve ratio (CRR), the ratio of deposits banks must keep with it, to 8.75 percent from 8.25 percent in two 25-basis-point stages on July 5 and July 19.

The RBI said a "continuous heightened vigil" was needed to respond swiftly to further developments and anchor inflation expectations, and economists did not rule out more tightening.

"In the remaining part of the year, there will be 50 basis points increase in CRR and 25 basis points in the repo rate," said Rupa Rege Nitsure, chief economist at Bank of Baroda.

Tuesday's move would boost the CRR 125 basis points this year, after hikes in April and May to drain excess inflation-stoking cash from the money markets. Economists expect banks will also raise rates.

Wholesale price inflation, India's most widely watched price measure, accelerated to a 13-year high of 11.05 percent in early June, the first inflation reading after the government increased state-set fuel prices at the start of the month.

In the previous week the rate had been 8.75 percent. It has doubled since February, largely on costlier oil, metals and food.

Not just supply side

The central bank said in a statement demand pressures were strong in an economy which grew 9.0 percent last fiscal year.

"At this juncture, the overriding priority for monetary policy is to eschew any further intensification of inflationary pressures and to firmly anchor inflation expectations," it said.

Indian policy makers are concerned rising inflation hits the poor hardest and, with state and national elections due this year and next, fear a voter backlash at the ballot box.

The RBI said an adjustment of demand was warranted to stop gains achieved from strong growth being eroded.

"The urgency of this broader albeit somewhat painful but timely contraction has to be viewed in the context of the new reality of high and volatile energy prices not necessarily being a temporary phenomenon any longer," it added.

D.K. Joshi, principal economist at rating agency Crisil, said the move aimed to control second-round effects of the recent fuel price rise and also other input cost increases such as steel.

"This move will bring down future demand and reduce the pressures on prices," Joshi said.

The central bank had been expected to make a move before its next review on July 29, after RBI governor Yaga Venugopal Reddy met the prime minister and finance minster at the weekend. The finance ministry said monetary policy should be the first line of defence to manage demand in Asia's third-largest economy.

But the extent of the tightening is likely to be a surprise to markets after Reddy seemed to suggest a more gradual move in a statement on Monday.

Abheek Barua, chief economist at HDFC Bank, said the step was extreme and the market had expected smaller increases in the policy rates. He saw the benchmark 10-year bond yield IN082418GCC climbing from Tuesday's close of 8.57 percent.

"The 10-year bond yield will move up to 8.8-8.9 percent and there is a possibility of a spike in yields in general across the curve," Barua said.

The yield hit 8.76 percent on Monday, its highest since November 2001.

Economists said banks' prime lending rates, extended to the best customers, were also likely to rise. Barua expected increases of half a percentage point.

The RBI's statement made no mention of the reverse repo rate, at which it absorbs excess cash from banks and which is currently at 6.0 percent. Nor did it refer to the bank rate, used to price longer term loans, and which is also at 6.0 percent.