The first task of any central bank, it goes without saying, is to keep inflation in check. Other concerns-growth being one-are secondary. In that sense, the Reserve Bank of India (RBI) is in danger of losing the plot. The facts speak for themselves.
Inflation, as measured by the Wholesale Price Index (WPI) was close to 9% (on a year-on-year or y-o-y) basis in March. This is way above the 5% mark, considered to be the central bank’s tolerance limit. RBI’s original expectation was for 7% inflation by March-end. This was revised to 8% later. Given the frequent upward revisions in WPI figures, it will surprise no one if the final March figure turns out to be in double digits.
Since March last year, the central bank has effected a 200 basis points (bps) increase in the repo rate and raised the reverse repo rate by 250 bps. In the normal course, this would be considered an aggressive tightening of monetary policy for any economy comparable to India. That this has not worked is clearly revealed by RBI’s data on inflation expectations. For each quarter from April-June 2010 to January-March 2011, the level of expected inflation has always outpaced actual inflation during the various survey periods.
What this reflects is not a lack of will on the part of RBI to fight inflation, but policy ineffectiveness due to the weakness of the steps: While overall a 200 bps increase in the repo rate may seem strong medicine, in reality 25-50 bps increases in the repo/reverse repo rates are hardly sufficient. Time lags and clogged transmission channels are sufficient to ensure that economic agents revise their inflation expectations to a higher level. Any strong medicine when dosed out in drops can turn into a homoeopathic concoction, useless in treating virulent fevers.
If there is a time for raising policy rates in a bold manner, this is it. Manufactured non-food inflation, which is more amenable to monetary cures, was at a high of 7.1% (y-o-y) in March, up from 6.1% in February. With global oil prices in triple digits, a correction in domestic fuel prices is a foregone conclusion, sooner or later. Tightening money supply will not hurt when that happens.
At the moment, the debate is by how much should RBI raise rates. One reason against a steep increase in the policy rates is that it will deter investment, which many expect to have turned negative in the final quarter of fiscal 2011. It is said that any rate hike now has the potential to deter investment demand in the quarters ahead. This is a weak argument. Investment depends on many other factors apart from interest rates. Governance and regulatory clearances matter more than rates. In any case, real interest rates are barely positive. RBI would do well to increase the repo rate by 50 bps on Tuesday.
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