Now that the repo rate (at which the Reserve Bank of India, or RBI, lends to banks) has been increased to 5.5%, it matches RBI’s inflation target of 5.5% by the end of March 2011. If we take RBI’s forecast as expected inflation, then the real policy rate, or the rate after adjusting for inflation, is now zero. Most economists differ with RBI and see inflation well above 5.5% by March 2011, which means that even after the hike, the real policy rate remains in negative territory. That is unlikely to deter borrowing and have any impact on growth.
It’s instructive to see what impact the rate hikes in March and April have had. The real economy has gone from strength to strength, seen from the very high growth in the Index of Industrial Production. The inflation numbers show that demand-pull inflation is rising. True, the stock market has been range- bound but that has little to do with monetary policy. Also, the BSE Auto index and the BSE Banking index, tracking two interest-rate sensitive sectors, have been doing rather well. The Auto index has long passed the pre-crisis high of 5,881 reached in February 2007 and is now at 8,184. The BSE Bankex is at 10,663, having crossed 11,000 in April—its pre-crisis high was 12,678 during its heydays in January 2008. The only rate-sensitive sector that has been hurt badly is real estate—the BSE Realty index is at one-third of its peak in January 2008, despite real estate prices having reached new highs in the metros. In the bond market, the yield on the benchmark 10-year government bond is currently well below the yields seen in February and March this year.
Graphic: Ahmed Raza Khan/Mint
Clearly, therefore, RBI needs to hike rates further. There are, however, some factors that may help it. One of them is the recent deceleration in manufacturing growth, as seen from the HSBC Markit Purchasing Managers’ Index (PMI). Another is slowing exports—they were lower month-on-month in May. And the third could be a levelling off of prices—the Manufacturing PMI index of output prices has fallen from 55.76 in April to 52.14 in June, while the index of input prices has come down dramatically from 65.15 in April to 53.56.