RBI raises interest rates – markets crash; what should investors do?

Regular readers of this blog should not have been too surprised by today’s selling, which followed the RBI announcement raising the repo and reverse repo rates by 50 bps (0.5%) each. In last Saturday’s analysis of the Nifty chart, I had mentioned the possibility:

‘The markets have already discounted a likely 25 bps interest rate hike by the RBI next week. If the actual hike is 50 bps, there can be more selling.’

The RBI governor had adopted a graduated raising of interest rates so far, taking baby steps of 25 bps on the past few occasions. Market players had expected a similar hike this time around, but were taken aback by the aggressive stance of the RBI. So, they decided to head towards the ‘Exit’ doors.

What signal is the RBI trying to convey? Inflation has now become a bigger concern than growth. It needs to be contained, even if growth slows down in the near term. Is that the right thing to do? What happens over the next few months will provide the answer to that question. Interest rate hikes take some time to percolate through the financial system.

The fact is, the earlier rate hikes of 25 bps at a time - in an effort to balance inflation and growth - has not really worked. Inflation continues to remain high, though it has reduced from double digits to single digit. The unrest in the Middle East caused a spike in oil prices that made the inflation situation even worse.

Thanks to the elections in a few states, petrol prices have not been raised. But they surely will be, once elections are over. Diesel, kerosene and cooking gas subsidies are huge burdens being borne by the oil marketing companies. At some point, diesel prices will need to be de-controlled. That will further stoke inflation.

The RBI governor decided to bite the bullet and tackle inflation with a heavier hand now. Higher interest rates will hinder the already slowing credit off-take and capex plans of India Inc. GDP growth in FY12 is expected in the 7.5% – 8% range. Not bad, but lower than earlier forecasts. Profit margins of India Inc. will reduce. That is why the sell-off happened today.

What should small investors do? Some times the best thing to do is to do nothing (and enjoy the extra 0.5% interest in your savings bank account that RBI doled out). Wait for the dust to settle, and the selling to subside. Then pick up some of the better stocks that may have been beaten up badly, and whose valuations start to look attractive.

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The Interest Rate hike was expected – why did the market fall?