The Hindu Business Line : RBI could hike, Fed cut, 25 bps

Two crucial events loom up this week. First, the RBI releases its Policy Statement for 2008-9 on April 29. The US Federal Reserve’s Federal Open Market Committee (FOMC) meets next on April 30 to decide interest rates. Indian markets are on RBI watch and global markets Fed watch.

The RBI’s pre-emptive 50 bps Cash Reserve Ratio (CRR) hike a week ahead of the annual policy statement has taken out the excitement. It is now clear that policy rates do not count as much as the CRR.

The RBI realised this in late 2006 when it found a complete disconnect between its repo rate and overnight money market rates. The CRR was a more effective tool to drive market rates towards policy rates. Since then there is greater CRR reliance to align the two rates.

Little choice

Rising inflation leaves the Indian central bank little choice but to keep pursuing its tightening mode. The latest data on industrial production hardly suggest a significant slowdown. India seems to have weathered the US economic and financial storms well.

Real interest rates are barely positive and corporate profitability remains well above gilt yields. Thus a 25 bps increase in the repo rate seems all but certain. But excess banking system liquidity will not be rewarded with an increase in the reverse repo rate.

In any case, given financial market volatility, the RBI is unlikely to wait till its quarterly Policy Statements to act on the liquidity and interest rate fronts. CRR and rate tinkering between meetings will become more frequent.

What of the FOMC? It has already cut 300 bps, lowering its benchmark Fed Funds rate from 5.25 per cent to 2.25 per cent.

More important, it has graciously agreed to swap its Treasury bonds for the mortgage bonds of banks, to impart liquidity to banks’ balance sheets.

As a result, credit spreads and credit default swap (CDS) prices have fallen in recent weeks. Bargain hunting by ‘vulture’ funds and other savvy investors have also revived prices a little. But the gap between LIBOR and Treasury bills is still an uncomfortable 150 bps+ - well over the normal few or a couple of tens of basis points. Worse, the Fed’s steep cuts have barely transmitted to mortgage rates.

Housing woes

The housing sector — the cause of all of today’s problems — is yet to see light at the end of the tunnel. Prices continue to fall and the inventory of homes looking for a buyer is rising.

But the Fed cannot ignore inflation risk. Core (excluding food and energy) inflation is above its informal target of 2 per cent.

On balance, it is probable that the FOMC will cut 25 bps and announce that further cuts will depend on an improving inflation situation and outlook.

It might also wait to gauge the impact of its aggressive interest rate and liquidity moves and the Government’s fiscal package effective May.

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