The 50 basis points (bps) increase in the repo rate by the Reserve Bank of India (RBI) was an even bigger surprise this time than the similar increase in early May 2011 (one basis point is one-hundredth of a percentage point). The question is, why now? In late April, with global commodity prices climbing, and the peak in inflation still some time away, the January-March quarter financials still looking strong, credit growth at close to 23%, front loading of rate increases might have been the logical policy response.
In the current environment, with an emerging consensus that inflation would peak around August/September (whatever be the peak level) and then drop off sharply from December, an uncertain global environment and increased signs of a domestic growth slowdown—particularly in investment—the seeming urgency and larger-than-expected tightening steps were more puzzling.
The reasons, stated and implied, were as follows. The persisting high inflation, despite the series of rate hikes (and RBI’s 325 bps cumulative rate increase has been one of the largest in the world), had clearly emerged as a serious concern, particularly in tandem with continuing strong, if decelerating, consumption demand.
This was also the first articulation of the unwarrantedly large role of monetary policy in inflation control, without the requisite “complementary policy responses on the supply and demand side”. There might also have been a bit of a gaming tactic in the move. If RBI’s perception was that banks and markets had completely priced in the widely expected 25 bps increase, there might not have been a response in bank base (and other lending) rates, defeating the purpose of the tightening exercise.
We have actually heard the argument that a 50 basis points rate increase at this time might have been a positive for investment sentiment, had it been accompanied by some signal that monetary policy was actually close to a peak.
While there is no overt signal of any such moderation in the momentum, RBI’s guidance has changed from “a need to persist with its anti-inflationary stance” to a stance which will “depend on the evolving inflation trajectory… with change motivated by a sustainable downturn in inflation”.
What are the implications for the policy stance? Given our view of the inflation trajectory, stated above, if there are no major negative shocks, there is a possibility that the rate peak might be just 25 bps away.
The worry is that the dominance of the monetary policy tool in inflation control might be silently fostering a systemic demand-supply imbalance. Very little capacity has been built up in the past few years, the effects of which is now evident, as in the sharp increase in the capacity utilization levels depicted in RBI’s own Obicus (Order Books, Inventories and Capacity Utilization Survey). Unfortunately, capex has relatively long gestation periods and increased policy uncertainty only serves to deter investment plans. In the face of sticky demand, unless investment activity picks up and capacity gets created quickly, there will be a resurgence of inflation, which will actually be an unintended consequence of policy actions.
Saugata Bhattacharya is a senior vice-president (business and economic research) at Axis Bank.
The views are the author’s own and do not necessarily reflect those of the institution to which he is affiliated.