Last week, the US Federal Reserve cut its short-term interest rate by 75 basis points, or three-quarter of a full percentage point, the second deepest cut at one go since the Fed started announcing its policy rate moves in 1994. With this, the US central bank now has cut its policy rate three full percentage points to 2.25% since September 2007, the fastest pace of easing interest rates in decades.
With the latest round of cut, the Fed policy rate has now gone back to where it was in December 2004.
Where was the Reserve Bank of India (RBI) policy rate at that time? Unlike in the US, there are two policy rates in India—reverse repo or the rate at which RBI sucks out liquidity from the system, and repo, or the rate at which the central bank injects liquidity into the system. In a liquidity-surplus situation, such as now, the reverse repo is the policy rate, and in a liquidity-starved situation, the repo is the policy rate.
In December 2004, when the Fed rate was ruling at 2.25%, which is also the current rate, RBI’s reverse repo rate was 4.75% and repo rate 6%. Since then, the reverse repo rate has risen to 6% and repo rate 7.75%.
Between September 2007, when the US rate was 5.25% and the Fed started its rate easing policy, and now, RBI has not changed its interest rates.
This means the interest rate differential between the US and India, which was 75 basis points—if one considers reverse repo rate as policy rate in India—has now widened to 375 basis points. In case the repo rate is considered as a policy rate here, then the rate differential has widened from 250 basis points to 550 basis points.
Theoretically, the widening of the gap between the US and Indian rates ensures higher capital flows and puts pressure on the local currency to strengthen. And yet nobody is expecting RBI governor Yaga Venugopal Reddy to rush to pare the rate and bridge the rate differential. This is because Reddy has a bigger problem at hand—the rising inflation rate.
The wholesale price based inflation has breached RBI’s comfort zone and rose to 5.92% in the first week of March, from 5.11% in the previous week.
Such a sharp spurt in inflation during a week was last seen almost three years ago, in April 2005. For analysts and economists, the sudden rise in inflation has not come as a shock as Indian inflation is actually catching up with the global trend. In Singapore, the consumer price inflation is now ruling at its 25-year high and in China it is at an 11-year high. For the government and policymakers in India, however, the panic button has been pressed. After all, only a few months ago in November 2007, the inflation was 2.97%.
The 80-basis point jump in inflation has dramatically changed the inflation trajectory for the coming fiscal and people have started talking about a 6-7% band for inflation in fiscal 2009, sharply higher than RBI’s projected inflation level of 5-5.5% and the medium-term goal of bringing it down to 4-4.5%. So, there is very little room for RBI to reduce its policy rates despite the widening rate differential between US and India.
Ever since it started its tightening cycle in October 2004, RBI has raised the reverse repo rate from 4.75% to 6% and the repo rate from 6.25% to 7.75%. It has also raised banks’ cash reserve ratio—the amount of money Indian banks need to keep with RBI—by 200 basis points to 7.5%, to soak up excess liquidity from the system, which stokes inflation.
There is no direct correlation between the US and Indian rates, but in the rising rate cycle, the Indian policy rate was raised by 25 basis points for every 75-100 basis points rate hike in the US. For instance, the reverse repo rate was raised by 25 basis points to 4.75% in October 2004 to catch up with the 75 basis points, three-stage rate hike by US Fed to 1.75% from its historic low of 1% in May 2004.
Overall, the Fed rate rose 425 basis points—from 1% to 5.25%—between June 2004 and June 2006. During this time, the Indian rate rose by 125 basis points, from 4.5% to 5.75%. Later, the reverse repo rate rose further to 6% and repo rate went all the way to 7.75%, while the Fed rate remained static at 5.25% between June 2006 and September 2007, when it made the first cut.
Now, when the US has reversed the trend, RBI is keeping quiet. And it is unlikely to cut its rates on 29 April when the annual monetary policy for fiscal 2009 is announced, despite tell-tale signs of a slowdown being visible across sectors. Indeed, banks’ loan growth has slowed considerably and industrial production growth of 5.3% year-on-year recorded in January was weaker than what was expected.
But Reddy has no choice. With the general election around the corner, the risk to inflation is a bigger worry than the risk to economic growth. Even those commercial banks that have cut their deposit and lending rates in recent time may start raising them if the high inflation rate persists for long.
This is because the inflation-adjusted returns or real interest rates for depositors are going down with the rise in inflation and banks will find it difficult to raise deposits unless they pay a little more. And if the deposit rates are raised, they would need to hike their lending rates too to protect their margins.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email ?comments? to? email@example.com?