As inflation continues to hover above its comfort zone, the Reserve Bank is likely to increase the short-term lending or repo rate by another 25 basis points in the monetary policy review due next week, American brokerage firm Morgan Stanley has said.
"As inflation, both WPI and CPI, remain elevated and surprised on the upside last month, we expect the RBI to increase the repo rate by 25 basis points to 7.75 per cent to anchor inflationary expectations," Morgan Stanley said in a note.
"This move will also help to achieve RBI's stated intent of eventually narrowing the gap between the MSF and repo rate to 100 basis points."
In September, the headline inflation accelerated to a seven-month high of 6.46%, while the retail inflation quickened to 9.84%.
The brokerage house also expect the RBI to cut the MSF rate by 25 basis points to 8.75% in the October 29 policy looking at the current stabilisation in the rupee and also due to increasing probability of delay in US Fed tapering of quantitative easing.
In mid-July, RBI had raised the MSF rate to 10.25% and also limited access to LAF by each individual bank at 0.5% of its net demand and time liability (NDTL) to curb rupee's fall by tightening the liquidity conditions.
However, the new RBI governor Raghuram Rajan eased the MSF rate to 9 per cent in two tranches after taking over charge on September 4.
The brokerage note said the RBI may reverse the quantitative tightening taken in July if it intends to cut short-term rates.
"We see the possibility of RBI taking some measures to reverse the quantitative tightening by way of increasing the magnitude of liquidity accessible at the repo rate," the note said.
However, Morgan Stanley believes an aggressive move to easy liquidity conditions in order to transition back towards making the repo rate the effective policy rate may be deferred to a later date.
The note said that to address the external funding stress in a systematic manner, the country needs a pro-cyclical fiscal tightening, which augments public savings, and a rise in real rates for households.
"In the context of the government's inability to quickly augment public savings by meaningful pro-cyclical fiscal tightening, lifting of real rates is the only credible way to demonstrate the commitment to reduce saving investment gap," the note said.
The note further said that persistent negative real rates since the credit crisis have been a key factor keeping deposit growth weak.
It expects that in the coming busy season, the credit-deposit ratio will rise to another new high.