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Policy rate should go up

Policy rate should go up
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First Published: Wed, Jul 14 2010. 07 25 PM IST
Updated: Wed, Jul 14 2010. 07 25 PM IST
Inflation as measured by the Wholesale Price Index rose 10.55% in June, from a year earlier. This is marginally higher than its 10.16 % rise in May, but lower than the number expected by analysts—closer to 11%. The 11.5% growth in the Index of Industrial Production, or IIP (or factory output), in May is also lower than analysts’ expectation of a 16% expansion. These are the two sets of key data that the Reserve Bank of India (RBI) will analyse before taking a call on raising its policy rates during its quarterly review of monetary policy on 27 July.
Three weeks ahead of the review, in the first week of July, RBI raised its reverse repo and repo rates by a quarter percentage point each for a third time since mid-March. The reverse repo, or the rate at which RBI drains liquidity from the financial system, is now 4%, and the repo rate, or the rate at which it infuses liquidity, is 5.5%. Since there is not enough liquidity in the system, banks are borrowing money from RBI daily and the effective policy rate is now 5.5%.
Even though both inflation as well as the IIP numbers are below analyst estimates, there is no reason for RBI to go slow on its rate-tightening cycle.
Indeed, the growth in industry, especially manufacturing, is slowing and the indices for capital goods, consumer durables as well as non-durables were all lower in May. But the main reason behind slower manufacturing growth is capacity constraints, not a fall in demand. Since demand continues to be high, capacity constraints will only lead to a rise in prices. Inflation has been in the double digits for five months in a row and will continue to remain so at least for one more month. In fact, it may inch closer to 11% in July when it reflects the increase in the prices of petroleum products fully. The government on 25 June deregulated the prices of petrol and raised the prices of diesel and cooking gas. The impact of this is expected to be a full percentage point increase in inflation.
The International Monetary Fund last week upgraded its 2010 economic growth forecast for India to 9.4%. RBI has also indicated that it would raise its growth projections for the economy from its earlier estimate of 8%. As the economy is on a firm recovery path, a quarter percentage point rate hike is called for on 27 July. And more will be required in coming months if inflation expectations are not reined in.
Is this the right time for tightening rates? Tell us at views@livemint.com
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First Published: Wed, Jul 14 2010. 07 25 PM IST