Expect RBI to hike repo rate to 8% by 2013-end: StanChart

1) RBI unexpectedly hikes the repo rate to contain inflation; we expect another 50bps of hikes in Q3-FY14

2) Despite our higher inflation forecasts, more easing of liquidity conditions is likely, including a 50bps reduction in the MSF
3) We expect the rates curve to pivotally steepen; stay Neutral GoISec duration and hold 2Y GoISecs
The Reserve Bank of India's (RBI's) surprise 25bps repo rate hike to 7.50 percent on September 20 policy meeting indicates to us that the new RBI governor is focusing more on inflation than growth.

Also Read: Brace for more repo rate hikes: Samiran Chakrabarty
We now expect the RBI to increase the repo rate by 25bps each at the next two policy meetings to 8 percent by the end of 2013. The reduction in the marginal standing facility (MSF) rate to 9.5 percent from 10.25 percent will help ease the pressure on banks’ wholesale funding; we expect the MSF rate to be reduced by another 50bps by end-2013.
At first glance, these two actions might appear contradictory. However, it is important to understand their different objectives. The purpose of the July hike in the MSF rate was to help defend the currency, while this latest repo rate hike is to address the re-emergence of inflation fears.
We expect this differentiation to continue and hence the pace of further MSF rate reductions will be a function of currency movements. In fact, we believe the RBI will also have to increase the liquidity adjustment facility (LAF) borrowing limit from 0.5 percent of net demand and time liabilities (NDTL) to bring the overnight call rate in line with the repo rate.
At the post-meeting press conference the governor mentioned inflows of about USD 1.4bn via the NRI FCNR(B) route and banks’ borrowing of Tier 1 capital in the last four days. These measures will be in place until 30 November and more inflows via these channels could further support the Indian rupee (INR) and make it easier to end liquidity-tightening measures.
Forecasting the extent of repo rate hikes is more difficult, and will depend on which inflation metric the new governor targets. Today he declined to comment specifically, mentioning that the committee set up under the RBI deputy governor is considering the matter and is expected to submit its report in three months‟ time. However, his plan to introduce a CPI-linked savings certificate shortly indicates that the emphasis on CPI is likely to increase. If such a shift happens, policy rates are likely to remain elevated for a considerable time.
In some ways, the new governor has maintained the stance of his predecessor. He is not making any distinction between the different inflation sources and is focusing on bringing down headline inflation, which is critical for inflation expectations.
Also, there is no change of stance on the role of monetary policy to support growth. The near-term obstacles to growth are not in the domain of monetary policy. The new governor shares the view that monetary policy can only support growth in the medium term by ensuring low and stable inflation.
Bringing down inflation by reducing demand-side pressures when supply constraints are acute is likely to prolong the slow-growth period. However, a substantial decline in CPI inflation and inflation expectations might reduce demand for gold. In turn, this could address current account vulnerability and encourage more financial savings. We agree that inflation is still a concern in the economy but the effectiveness of using interest rates to address food and fuel inflation is open to question.