Reining in Inflation

In an attempt to rein in inflation, the Reserve Bank of India (RBI) has raised its key policy rates in the mid-quarter review of its monetary policy on 17 March 2011, the eighth increase in the past one year. This time it seemed to be in line with expectations of most economists and bankers as rising commodity prices were fuelling domestic inflation. The repo rate at which the RBI lends to banks and the reverse repo at which it borrows from them were increased by 25 basis points (bps) each, bringing these to 6.75% and 5.75%, respectively. One bps is one-hundredth of a percentage point.

“Clearly, the RBI’s agenda is to check demand-side inflationary pressures. By increasing rates, the cost of lending also goes up and people have to pay more for loans. Hence, it raises the barrier for speculative demand,” says Ritesh Jain, head, fixed income, Canara Robeco Mutual Fund.

Experts say that the central bank may hike rates in future as well. “The RBI has also increased its inflation forecast to 8% for March 2011 from the earlier 7%. This indicates that a few more hikes are likely going forward,” says Mahendra Jajoo, executive director and chief investment officer, fixed income, Pramerica Mutual Fund.

According to the RBI, further upside risks to inflation have stemmed from increase in prices of crude oil, coal and non-food manufactured products. Although food inflation has moderated, fuel prices are adding to the basket. At 8.31%, inflation was higher than expected in February. Inflation was at 8.23% in January.

“The RBI may raise rates by another 50 bps considering that inflation continues to be above the central bank’s comfort levels and real interest rates are still in negative territory. We could see shortterm rates stabilise around the current levels, but there is still no clarity on long-term rates as high oil and food prices pose risk of high inflation,” says Jajoo.

If you are looking at investing in fixed-income funds, experts advise looking at short-term funds. “A clear trend on long-term rates will emerge only by June when early indications are available for the monsoon, says Jajoo.

The other option would be to capture high fixed deposit rates offered by banks. Fixed deposit interest rates are just about touching the 10%-mark and with the RBI’s rate hikes, they could yield better returns.

“Bank deposit rates would remain around same levels in the next quarter as banks have already increased their rates significantly in the past few months and have seen increased mobilisation,” Jain says.

Fixed maturity plans (FMPs) are another option in the rising interest rate scenario as they lock in the money in fixed maturity bonds and do not suffer mark-tomarket losses. While these are less susceptible to interest rate vagaries, your return can be higher by 1-1.5% than bank fixed deposit rates.

The global economic scenario is likely to dictate the RBI’s policy decisions. “The sharp increase in oil prices as a result of the turmoil in the West Asia and North Africa is adding uncertainty to the pace of global recovery,” the RBI said in its review. “Although, it may be too early to assess the macroeconomic consequences of the natural disaster in Japan, the substitution of thermal for nuclear energy in Japan may exert further pressure on petroleum prices.”