Reddy should hike rates

Reddy should hike rates
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First Published: Mon, Jul 28 2008. 11 41 PM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Mon, Jul 28 2008. 11 41 PM IST
Monetary policy is partly a mind game. And Reserve Bank of India (RBI) governor Y.V. Reddy will have to be careful about what signals he sends out in the monetary policy that he will announce today.
The markets clearly expect another increase in interest rates. This crushing consensus is one indication of how Reddy has got them aligned with his views on growth and inflation. RBI was under fire from many quarters when it started increasing interest rates; now only a few loose cannons are firing at it. There is little doubt elsewhere that Indian interest rates are still too low for an economy battling double-digit inflation.
Illustration: Jayachandran / Mint
Curiously, this consensus has solidified at a time when there is a strong case for not increasing interest rates right away. The recent drop in global oil prices suggests that the commodity bubble may have been pricked. Remember: Oil prices have not dropped because there are more supplies in the market. They have fallen due to a fall in demand. It is possible that similar demand destruction will be seen in other commodities later this year. That will take some pressure off prices.
Meanwhile, there are signs that the economy is slowing, partly in response to RBI’s tightening. Industrial output growth in May was at a six-year low. This combination of slower economic growth and lower commodity prices is a good reason for Reddy to hit the pause button and do nothing today.
But we would argue against this course of inaction. The temporary relief from oil should not lull us. Inflation is still way too high; the current drop in oil prices will do little to take it into safe territory. The massive fiscal deficit does feed aggregate demand. The wider current account deficit and strong growth in non-oil imports suggest the economy is still overheated. Money supply and bank credit are rising too fast.
A pause right now will send out the wrong signal. Agents have just started adjusting to the prospect of higher interest rates. This applies to firms building new capacities and households seeking home loans. A pause could make them believe that interest rate hikes have peaked — and they may start borrowing and spending once again. That is something Reddy just cannot afford to do right now.
Forget the short-term palliatives that point to a pause. The long-term challenges demand higher interest rates. Reddy should not send conflicting signals.
Should interest rates go up further? Write to us at views@livemint.com
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First Published: Mon, Jul 28 2008. 11 41 PM IST