India's central bank raised its policy rate by 25 basis points to 8.0 percent, its third rate rise since September 2013, but said it did not expect to tighten its policy further in the near term as long as inflation evolves as expected.
The Reserve Bank of India (RBI), which last month said it was poised to raise rates if inflation didn't decline, acknowledged that wholesale price inflation had fallen significantly in December due to lower vegetable prices but excluding food and fuel inflation had risen.
It is the second month in a row that the RBI has surprised financial markets. Economists had expected the RBI to maintain rates today given the drop in wholesale price inflation to 6.16 percent in December from 7.52 percent the previous month. The decision to maintain rates in December also took markets by surprise as November inflation had risen and the RBI was expected to raise rates.
But the RBI has now adopted consumer prices instead of wholesale prices as its main inflation gauge, following a recommendation last week by a committee chaired by Urjit Patel.
The committee recommended that the RBI should set an objective of CPI inflation below 8 percent by January 2015 and below 6 percent by January 2016. In the long term, the committee recommended an inflation target of 4 percent, plus/minus 2 percentage points.
In December India's CPI inflation fell to 9.87 percent from November's 11.16 percent and the RBI said the projections "indicate that over the ensuing 12-month horizon, and with the current policy stance, there are upside risks to the central forecast of 8 percent."
"An increase in the policy rate will not only be consistent with the guidance given in the mid-quarter review but also will set the economy securely on the recommended disinflationary path," the RBI said.
It added that the "extend and direction of further policy steps will be data dependent, though if the disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture."
In its accompanying report on economic developments, the RBI said CPI inflation is expected to remain above 9 percent in the fourth quarter of the fiscal year 2013-14, which ends March 31, and range between 7.5 and 8.5 percent in the fourth quarter of FY 2014-15, with the balance of risks tilted to the upside.
If the RBI is succeeds in reducing inflation to its target, India's economic growth is expected to improve to around 5.5 percent in FY 2014-15, which begins on April 1, compared with a little below 5 percent for the current 2013-14 year.
"A pick-up in investment in an environment in which external demand continues to be supportive of export performance could impact an upside to this forecast," the RBI said.
India's Gross Domestic Product expanded by an annual 4.8 percent in the third calendar quarter, up from 4.4 percent in the second quarter.
The RBI expects some loss of growth momentum in the October-December quarter with industrial activity still contracting, weaker consumer demand and lackluster capital goods production due to stalled investment demand. Fiscal tightening is also likely to exacerbate the weak demand.
But although the global recovery is gaining traction that will help boost demand, the RBI said "uncertainty continues to surround the prospects for some emerging economies, with domestic fragilities getting accentuated. Financial market contagion is a clear potential risk."
India's trade deficit for the first nine months of fiscal 2013-14 has shrunk by 25 percent from its level last year and the current account deficit for 2013-14 is expected to be below 2.5 percent of GDP compared with a deficit of 4.8 percent in 2012-13.
"The recent resumption of portfolio flows, both equity and debt alongside the pick-up in FDI and external commercial borrowings that is underway should help finance the currency account deficit comfortably," the RBI said.
In its third quarter review, the RBI did not make any comments about the rupee.
The rupee weakened sharply from May through August, along with many other emerging market currencies, before bouncing back in September.
Since then it has been largely stable until
last week when concern over China triggered weakness in many emerging market
currencies and the rupee again fell. Earlier today the rupee was trading at 63.07 to
the U.S. dollar, down 1.8 percent since last Monday. Compared with the end of
2012, the rupee has lost 13 percent.
While the RBI raised its policy rate, it held the cash reserve ratio (CRR) steady at 4.0 percent. But in line with the rise in the policy rate, the marginal standing facility rate and the Bank Rate were raised by 25 basis points to 9.0 percent and the reverse repo rate is now at 7.0 percent.
In its economic report, the RBI also said there were foreign disinvestments of over US$13.4 billion ($10.5 billion in debt and $2.8 billion in equity) from the first sign of tapering of asset purchases by the U.S. Federal Reserve and Sept. 3, with the rupee depreciating by 17 percent and foreign exchange reserves depleting by nearly $17 billion.
But since then, the rupee has appreciated by 6.7 percent, the loss of reserves has been more than fully recouped and capital flows have resumed, with net investment of $9.1 billion in equities from Sept. 3 to Jan. 24, and debt flows have turned positive, with net investments of $3.8 billion.