The nail biting finish to India’s interest rate hiking cycle finally came on Tuesday, as Reserve Bank of India governor D. Subbarao signaled there was little likelihood of further rate increases in the December review, after a further 25 bps increase in the policy rate. As no central banker would commit without a caveat, this assumes that the inflation path unfolds as expected and evolving macroeconomic conditions. The monetary policy stance thus shifted, for the first time in many months, to accommodate growth concerns through stimulating investment; liquidity conditions will henceforth remain moderately in deficit in accordance with a shift in balance between inflation and growth.
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This was one of the closest calls in recent times as the tradeoff between inflation and growth reached a flashpoint. Given that monetary policy is forward-looking, there was a strong case for no further action: lower peaks and lower troughs from April 2011 indicated a clear downtrend in oil prices, which matter most for India’s inflation.
RBI governor D. Subbarao (C) along with deputy governors H. R. Khan, K. C. Chakrabarty, Subir Gokarn and Anand Sinha on their way to announce second quarter review of the monetary policy in Mumbai on Tuesday. (PTI photo)
But the rupee’s endless fall complicated matters by adding to the price pressures, subtracting the gains that could have been had instead. Worse, the exchange rate depreciation also pushed the central bank to increase the weight upon the interest rate tool to check inflation.
Will this hike percolate to the banks? The 25 bps increase of 16 September was not transmitted to consumers or even observed in the banks’ demand for resources: the weighted average of overnight rates in the money market (7.78%) remained below the policy rates in September. Overnight rates in October - when money market borrowings rise due to festival demand - have averaged 8.20% so far. Credit demand is subdued so far: seasonally adjusted monthly momentum in nonfood credit (three-month moving average) shows a consistent decline since February 2011 on an annualized basis; it fell to a 9.5% low this September; % and banks’ investments in government securities (31%) are way above the binding limit with their credit-deposit ratio stuck at 74 for several months. Banks are being cautious to transmit in fear of causing further injury to strained assets too. Since banks have to consider both credit demand and resource costs in deciding their prime rates, it remains to be seen how the balance between absorption of an increase in the cost of resources and transmission to borrowers works out this time round.
This has been some battle. Thirteen interest rate hikes since March 2010 and an effective tightening of 500 bps, although the way down in September 2008-March 2009 was a steeper fall. And not done yet even as inflation prospects look better than they’ve done for a long time now. The economy could do with the respite for, at this point, macro policy flexibility is significantly reduced by the trio of high inflation, large fiscal gap and widening current deficit that is increasingly fed by fickle short-term portfolio flows.
Renu Kohli is a macroeconomist and a former staff member of the International Monetary Fund and the Reserve Bank of India.