Finally, the much-anticipated interest rate tightening process has begun. A combination of high inflation, smart industrial recovery and robust demand for the last six months had led to expectations of a return to normalcy in monetary policy.
The Reserve Bank of India (RBI) signalled that late last week when it announced an increase of 25 basis points from 4.75% to 5% in the repo rate, the rate at which it lends money to banks. It also increased the reverse repo rate, or the rate at which it pays banks for parking money with it, by 25 basis points from 3.25% to 3.5%.
What RBI is doing is to return monetary policy to a normal stance and this cannot be construed as a “monetary tightening”. In the Indian context of a high growth, high inflation situation, a return to the 2008 position, when the repo rate stood at 8%, is normal. If the central bank is to raise the repo rate by, say, 150 basis points in one year, it makes much sense to go in for small, calibrated, increases. Big increases will not only roil credit markets but will also spook the equity market.
Illustration: Jayachandran / Mint
This must be understood, as the RBI press release noted, in the context of efforts to anchor inflationary expectations. In February, inflation (based on the Wholesale Price Index) galloped to 9.89%, the highest since 2008. Food inflation touched double digits some time ago and is now spilling into manufactures and other articles. So the old debate that food inflation was driven by supply-side constraints and hence had little to do with monetary measures is outdated. Equally out of place are concerns that interest rate increases may lead to a rise in the cost of borrowings by firms and hence pose a danger to growth. The steady rise in output, as shown by the Index of Industrial Production figures over the last six-eight months, shows that this concern is unwarranted. Increases in policy rates are the way forward.
The question here is how to do that effectively. This must be seen in light of the lags that accompany such announcements and their impact and the expectations of the many economic agents in diverse markets. If RBI were to raise the policy rates on preset dates, these expectations would already have been anticipated by these agents and factored in in their decisions. In such situations, an unorthodox approach such as that of unanticipated announcement dates has an important role to play in the efficiency of policy measures.
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