By hiking the policy rate after more than a year, Reserve Bank of India (RBI) governor Yaga Venugopal Reddy has restored the credibility of the Indian central bank.
In April, while announcing the annual monetary policy for fiscal 2009, he raised banks’ reserve requirement (defined by the cash reserve ratio, or CRR), or the cash they need to keep with the Indian central bank, by a quarter percentage point to 8.25%, the highest since 2001, continuing his fight against rising inflation. He left the rates unchanged, but dropped a clear hint that he would not hesitate to raise them, saying RBI would use “all the policy instruments at its disposal flexibly, as and when the situation warrants”.
The time was ripe to bite the bullet. Had he decided to wait till 29 July, when RBI meets for the quarterly review of its monetary policy, he would not have gained anything as there wouldn’t have been any substantial change in the macroeconomic scenario, but the central bank would have lost its credibility.
Wholesale price-based inflation, hovering around 7.6% in end April, has shot up to close to a four-year high of 8.24% now. More importantly, inflation expectations have been rising every week and, with the rise in fuel prices, analysts were expecting the inflation rate to hit double digits soon, miles away from RBI’s comfort zone of 5-5.5%.
Till recently, an appreciating rupee had been helping RBI in its efforts to rein in inflation by bringing down the cost of imports. However, with the rupee losing more than 7% against the greenback since April, one of RBI’s key inflation management tools has lost its relevance.
In the April policy, Reddy spoke about the “extraordinary degree” of global “uncertainties”. These uncertainties have only intensified since, with no respite from the rising commodity and oil prices. Even the US Federal Reserve, which has cut its benchmark lending rate from 5.25% to 2% in stages since September, has started dropping hints of raising rates.
In his latest remarks on Monday at the Boston Fed’s annual economic conference in Chatham, Massachusetts, Fed chairman Ben Bernanke issued a stern warning that the Fed would be on heightened alert against inflation dangers and “strongly resist an erosion of longer-term inflation expectations”. It may not raise rates in the last week of June, when its policymaking body Federal Open Markets Committee meets, but the rates could go up as early as September.
European Central Bank president Jean-Claude Trichet, speaking at the bank’s recent monetary policy meeting, too, signalled the possibility of a rate hike as early as next month in the face of deteriorating inflation outlook.
ECB left the rate unchanged at 4% at its meeting in the first week of June but considered raising rates.
After taking over as RBI governor in September 2003, Reddy started the monetary tightening cycle in October 2004. Since then, till this hike, he has raised the reverse repo (or the rate at which RBI borrows from banks) rate from 4.75% to 6% and the repo rate (the rate at which RBI lends to banks) from 6.25% to 7.75%, apart from raising CRR, draining excess liquidity from the financial system. Since April last year, CRR has been raised by 175 basis points to 8.25% but the two policy rates have been kept unchanged for quite some time. The repo rate was last raised in July 2006 and there has been no change in the reverse repo rate in more than one year now.
The market had started interpreting this as Reddy’s bias in favour of growth—he has been following an easy money policy, accommodating the pricing pressures even though they were not necessarily demand-driven.
In a sense, RBI’s monetary policy stance resembles that of the Chinese central bank—tightening liquidity through higher reserves requirement instead of raising interest rates. China raised reserve requirements five times this year. Reddy, too, probably felt that CRR was a more potent monetary tool than interest rates at this juncture as a hike in interest rates would attract higher capital flows and affect India’s growth.
Besides, RBI has also been selling bonds under the market stabilization scheme (MSS) to soak up excess liquidity.
But clearly, a hike in CRR and flotation of MSS bonds are not enough to contain the rising inflation and the inflationary expectations. Besides, liquidity is no longer a problem for RBI as capital flows have completely dried up. Till recently, the central bank was buying dollars from the market, releasing rupee liquidity. But now, it is actually selling dollars to meet the foreign currency demand of oil firms. So, a hike in CRR would not have served the purpose. The only way to kill inflationary expectations was a hike in interest rates.
This also reminds us of the relevance of the term NAIRU—an acronym for non-accelerating inflation rate of unemployment. Since we do not track employment data, in the Indian context, we can talk about NAIRG or non-accelerating inflation rate of growth. There is a correlation between the rate of growth and rate of inflation and it is impossible to simultaneously target high growth and low inflation. There is a trade-off and, finally, Reddy seems to have curbed his ambition for high growth and opted to control inflation through a rate hike.
The spurt in inflation is no surprise if one takes into account the rate of growth of the Indian economy in the past few years. While the nominal growth rate (that is growth rate plus inflation rate) has been between 14% and 15%, the policy rates have been less than half of it and bank credit has grown more than 30% for three years in a row till 2007. This is clearly unsustainable. First, we saw the rise in asset prices and then the inevitable followed—the rise in prices of goods and commodities.
A high growth rate cannot be sustained for long on cheap money alone. The government needs to make necessary structural changes, clear infrastructure bottlenecks and build capacity to support the growth story for longer term.
RBI has no role to play here.
Of course, Reddy could have still refrained from raising rates and left the job of addressing our inflation woes to Bernanke and Trichet. If both the US Fed and ECB go for a rate hike, global commodity prices will be tamed and India will indeed stand to benefit from that, but the Indian central bank’s credibility would have been eroded.
(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)