Revising interest rates in intervals between monetary policy meetings is not uncommon for the Reserve Bank of India (RBI). Keeping that in mind, its decision to raise key policy rates by a quarter of a percentage point each a month ahead of its annual policy review is no surprise, but it could have been avoided had the central bank increased rates in January along with the cash reserve ratio (CRR), or the portion of deposits that banks need to keep with RBI. In fact, some members of the technical committee that advises RBI on monetary policy favoured a rate hike in January, but RBI preferred to adopt a wait-and-watch stance.
In an interview with this newspaper after its January policy review, RBI deputy governor Subir Gokarn, who is in charge of monetary policy, said mid-cycle actions are in response to completely unforeseen events. “If there is a global slowdown of some significance and something happens which is not in line with our assumptions, that may provoke some action but, as far as possible, we want to operate on a schedule,” he said.
What has changed since January that provoked RBI to raise rates ahead of its April policy review? Economic recovery has gained pace with industrial production rising, exports expanding after contracting for 13 months and companies and individuals raising bank loans. Are these developments unforeseen? No one would say so.
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RBI seems to be worried about rising inflation, but even this is not unforeseen, though, not in line with RBI’s assumptions. From 8.68% in January, the wholesale price-based inflation rose to 9.89% in February, exceeding the central bank’s end-March projection of 8.5%. By March, many analysts predict, the wholesale price inflation will cross 10.5%. These analysts have been projecting double-digit year-end inflation for quite some time, but RBI refused to see the writing on the wall.
Officially, the government is not ready to give too much importance to inflation. In a recent interview with CNBC-TV18 television channel, chief economic adviser Kaushik Basu said: “The overall picture is not alarming as it appears at first sight when you look at 9.89%… I would expect March to be roughly the same kind of inflation that you have seen; (it) begins to slow down a little bit from April, and by May-June slows down quite a bit.” Basu expects inflation to dip below 5% in the second half of the calendar year (“it should cool down completely”). In this interview, given after the February inflation figures were released, Basu also said he was sticking to the ministry’s calculation for the next year of 4% inflation and “that is realistic enough”.
If indeed inflation slows from April and drops to 5% in the second half of the calendar year and to 4% by April 2011, why was RBI in a hurry to raise rates? There are three possible explanations:
a) RBI had erred in its inflation projection in January and now doesn’t see any dramatic drop in inflation too soon.
b) Given a choice, RBI would have preferred to wait till April to hike the rates, but there’s intense political pressure and it was imperative for the central bank to be seen acting to contain inflation.
c) RBI was all along well aware of the inflationary pressures, but the government did not want the central bank to spoil the party.
Since the central bank finally decided to bite the bullet, it could have avoided a half-hearted approach and gone for a more emphatic half-a-percentage-point rate hike.
As long as there is excess liquidity in the system, a quarter percentage point rate hike will not serve the purpose. In a liquidity-surplus situation the rate at which RBI drains money from the system, known as the reverse repo rate, is the policy rate. Only when banks run out of liquidity and start raising money from RBI will the 5% repo rate become the policy rate. RBI will have to be more aggressive in making money dearer by raising both rates as well as CRR if it wants to kill inflationary expectations.
The mid-cycle action is unlikely to make the April policy a non-event. I would expect another quarter percentage point hike on 20 April. It could be accompanied by a small CRR hike as well as there is plenty of money in the system. But RBI can’t afford to be very aggressive in draining out excess liquidity at this point as it needs to manage the government’s Rs3.45 trillion market borrowing programme and the bulk of this will be raised in the first half of the year.
RBI had started “managing” the economic recovery by signalling an end to its expansionary monetary policy in October, when it shut all refinance windows and raised the floor for banks’ holding of government bonds from 24% to 25% of their deposits. Many of its actions were, however, academic in nature as the refinance facilities had hardly been used. Similarly, a one percentage point hike in government bond holdings theoretically meant withdrawal of liquidity from the system and less money with banks for lending, but there was no impact on liquidity because banks had already invested a higher portion of their deposits in government bonds. In two phases spread over February 2010, RBI raised banks’ CRR by three-fourths of a percentage point and drained out Rs36,000 crore from the financial system to guard against excess liquidity stoking inflation. The rate hike is the next logical step. It may slow the pace of recovery, but that’s a small price to pay for taming inflation.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at firstname.lastname@example.org