Will Reserve Bank of India, or RBI, governor Yaga Venugopal Reddy call a truce in his war on inflation when he unveils the quarterly monetary policy review on 29 July, and leave interest rates unchanged? Or, will he continue to tighten policy by raising interest rates and soaking up liquidity through an increase in commercial banks’ cash reserve ratio, or CRR, in the belief that the beast of inflation is yet to be caged?
The market is divided on the stance of the July review, the last in the Reddy regime. Those bankers and bond dealers who strongly feel that the time is ripe to rein in Reddy’s aggression in raising rates, cite three developments to build their argument. First, the drop in the wholesale price-based inflation from 11.91% to 11.89% for the week ended 12 July, the first such drop in two months. Second, a decline in industrial production. The year-on-year growth rate in industrial production in May fell to 3.8%, its lowest in six years. Finally, they point to a drop in crude oil prices.
Since the beginning of the current fiscal, Reddy has raised the policy rate by 75 basis points to 8.5% and CRR by 125 basis points to 8.75%. One basis point is one-hundredth of a percentage point. These bankers and bond dealers feel any policy action at this juncture is not necessary and RBI should wait and watch the trajectory of inflation as well as the monsoon before taking a call on further rate hikes.
But there are others who equally strongly feel that it’s too early to wave the white flag and RBI should continue what it has been doing—making money dearer by raising policy rates. I would go with this group. Inflation is a bigger enemy than the slowdown and there is no room for complacency. At 11.89%, inflation is still more than double of what the central bank is comfortable with. More importantly, a drop of 2 basis points does not mean that inflation has reached its peak, particularly when the base effects will continue to remain unfavourable for the next few months. It had fallen from 4.7% to 3.1% between July and October last year and, because of the lower base, inflation will continue to remain in double digits for quite sometime and may not come down before the year-end. An uneven monsoon can queer the pitch further as it will impact food prices. So far, 14 out of 36 meteorological sub-divisions across India have received either deficient or scanty rainfall, the worst distribution of rain in four years.
Indeed, supply constraints are contributing to the rising inflation. But there are demand pressures too. There is no drop in investment demand as well as demand for consumer durables. Besides, non-oil imports are rising at a considerable pace.
The year-on-year growth in money supply has marginally come down to 20.5%, from 21.8% last year, but it is still well above the RBI projection of 16.5-17% for 2009. Similarly, aggregate deposits in the banking system have grown by 21.7% this year against RBI projection of 17% and credit growth has been 25.7%, substantially higher than RBI’s target of 20%. All these indicate growth impulses and monetary policy, the proverbial first line of defence against inflation, should come to the fore by raising the policy rate by 25 basis points or so.
There may not be any need to raise CRR at this point, as liquidity is already tight. Banks, on an average, borrowed around Rs45,000 crore daily from RBI last week and the rates in the overnight call money market, from where banks borrow to tide over their temporary asset-liability mismatches, have been hovering around 9%, above RBI’s policy rate.
Death of bank rate?
Is the bank rate, RBI’s most potent signalling device, dead? The last time this rate was tinkered with was in April 2003, when it was brought down by 25 basis points to a three-decade low of 6%. Since then, there has been no change in the rate even though the reverse repo rate has gone up from 4.5% to 6%, and the repo rate from 6% to 8.5%. The reverse repo rate is the rate at which banks park their short-term excess liquidity with RBI and the central bank pumps in short-term liquidity into the system at the repo rate.
Earlier, the bank rate was the refinance rate at which banks used to draw down liquidity support from RBI. But this has now been delinked from the refinance rate. The bank rate is a statement of RBI’s views on interest rates in the medium term, while repo rate is a short-term signalling device. But how “medium” is the medium-term view?
One can always argue that there are too many policy rates and why add another, especially one that has not been changed in a long time. But then, the bank rate is a signal of where medium-term interest rates should be and, by implication, where medium-term inflation is likely to settle. In an environment where managing inflationary expectations is the central bank’s most important job, wouldn’t it be wise to increase the bank rate?
The real policy rate is now at -339 basis points (inflation at 11.89% and repo rate 8.5). Since double-digit inflation is here to stay for at least a few more months, isn’t it better to give a medium-term signal to the market and be perceived as being ahead of the curve? In spite of the 125 basis points increase in CRR and 75 basis points rise in the repo rate, the corresponding hikes in banks’ lending rates are far lower. An increase in the bank rate will encourage banks to raise their lending rates and make money costlier.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org