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Keep hiking rates to cool inflation: IMF

Keep hiking rates to cool inflation: IMF
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First Published: Wed, Jan 05 2011. 10 30 PM IST
Updated: Thu, Jan 06 2011. 08 02 AM IST
New Delhi: The International Monetary Fund (IMF) says the Reserve Bank of India (RBI) should maintain a tight monetary policy stance and keep raising interest rates to tame inflation, which it sees as the key macroeconomic challenge.
In its annual advisory to the Indian government, IMF has projected inflation at 6.5% by the end of this fiscal year, one percentage point higher than RBI’s own forecast, although the central bank has conceded that the rate could exceed its projection.
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IMF’s advice is significant given that a fierce debate is under way among policy planners within the government on the wisdom of increasing interest rates at the risk of choking off growth momentum in the economy, forecast by the government to expand 8.75% in the current fiscal.
In its last monetary policy review on 16 December, RBI had left interest rates unchanged.
“Issue at hand is underlying inflation (inflation after excluding food and fuel prices) has been increasing quite rapidly,” said Sanjaya Panth, IMF’s senior resident representative in India, explaining the stand of the multilateral agency.
According to Panth, IMF’s sense is that interest rates are “negative in real terms and overall risks are on the upside”.
“Going forward, rising domestic input costs for the manufacturing sector, combined with aggregate demand pressures, could weigh on domestic inflation,” RBI said in its policy statement on 16 December. “The risk to the Reserve Bank’s projection of 5.5% inflation by March 2011 is on the upside.”
Since March, RBI has raised key policy rates six times. The repo rate, or the rate at which the central bank lends to banks, was last increased by 25 basis points to 6.25% on 2 November. One basis point is one-hundredth of a percentage point.
In November, inflation, as measured by the Wholesale Price Index, was 7.48%. During the five-month period between March and July, inflation was in double digits.
“RBI is likely to increase interest rates to deal with inflation, but supply-side constraints, particularly of food, have to be dealt with by the government to deal with long-term issues of inflation,” said D.K. Joshi, chief economist at rating agency Crisil Ltd.
IMF expects the Indian economy to grow 8.75%—the same as the government’s forecast—in the current fiscal and by 8% in 2011-12.
The finance ministry, in its mid-year economic review in December, revised upwards its forecast for economic expansion in 2010-11 to 8.75%, plus or minus 0.35 percentage point from the earlier estimate of 8.5%.
IMF’s views on economic growth, inflation, interest rates and other macroeconomic issues have been sent to the government as a part of the annual Article IV consultations. Under this section of IMF’s Articles of Agreement, the fund holds bilateral discussions with its member countries on the economy.
Subsequently, the agency’s managing director summarizes the fund’s views and conveys them to the member country.
IMF’s views on the Indian economy are scheduled to be placed in the public domain on Thursday.
In its latest Article IV summary, IMF has praised Indian policymakers’ management of the economy after the 2008 global financial crisis.
Economic growth has been strong, driven primarily by domestic demand, especially infrastructure investment, IMF’s summary said.
According to Panth, a move by the central bank to increase interest rates now to combat inflation would not hurt growth drivers such as investment. “Growth is a medium-term story,” he said. Over the medium term, there is no trade-off between inflation and economic growth whereas addressing inflation is an immediate priority, he added.
“Primary tool RBI has is the policy rate,” Panth said, explaining that raising interest rates were the best bet to combat inflation.
Other than interest rates, exchange rates are also a part of the central bank’s tool kit to manage inflation.
According to Panth, RBI has been flexible with its exchange rate management. In the last year, the central bank restricted intervention to smoothen volatility in the foreign exchange market.
Given that crude oil makes up around one-third of India’s imports, an appreciating rupee should dampen inflation by making imports cheaper. According to RBI, however, currency appreciation has only a limited impact on inflation in India.
“Empirical research shows that in the Indian context, the pass-through is quite low—in the range of 0.4-0.9%,” RBI governor D. Subbarao said in an interview carried in a December RBI publication.
Graphic by Uttam Sharma/Mint
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First Published: Wed, Jan 05 2011. 10 30 PM IST
More Topics: IMF | RBI | Inflation | Economy | GDP |