Is India ready to raise interest rates?3 min read . Updated: 13 Oct 2009, 05:20 PM IST
Is India ready to raise interest rates?
Is India ready to raise interest rates?
Mumbai: Expectations are rising that Reserve Bank of India (RBI) will have to start raising its extremely low interest rates as inflation is set to accelerate, although policymakers are fearful of moving too soon.
The central bank has been preparing markets for tighter policy while government officials have underlined the need to maintain pro-growth measures.
The RBI is due to hold a quarterly policy review on 27 October. A rate rise is unlikely, but the RBI might raise cash reserve requirements for banks as an influx of foreign funds adds liquidity to the financial system.
Why is the RBI expected to tighten policy?
Data on Monday showed industrial output in August jumped from a year earlier at its fastest pace in 22 months, far surpassing expectations as demand for consumer durables goods jumped.
Inflation is expected to pick up rapidly as economic activity improves and as the dampening effect of last year’s high energy and commodities prices falls out of inflation calculations.
Wholesale inflation was just 0.7% in the 12 months to 26 September. By the end of the fiscal year in March though, the finance ministry sees it between 5% and 6%. Some private analysts say it could reach that level as soon as December and 8% or more by March.
The central bank’s comfort zone is seen as roughly 5%.
The surge in sales of consumer durable goods, partly from stimulus spending, shows demand-side pressures building. An expected pick up in exports and credit growth will add to inflation pressures.
India avoided the deep recessions of many other countries during the global downturn. Growth slowed to 6.7% last year after hitting at least 9% in the previous three years. The government sees growth this fiscal year of roughly 6.3 to 6.5%.
Will the RBI take action at its 27 October review?
The central bank is unlikely to raise its two key policy rates, but an outside risk is that it will raise bank cash reserve requirements, or the cash reserve ratio (CRR).
A Reuters poll shows the central bank is expected to hold off from raising rates until April-June 2010.
The central bank cut its main lending rate by 425 basis points between October and April to 4.75% as the global downturn struck. It slashed the CRR to 5% from 9% between October and January.
Some analysts say Monday’s industrial output data was inflated by a low base of comparison, the effects of stimulus spending and pent-up demand ahead of the festival season.
Such growth might not be sustained and exports and credit demand remain weak.
“The fact that credit pickup is still gradual and that underlying risks still remain, I think will hold their hand from doing anything," said Macquarie economist Rajeev Malik.
“The talk will turn a bit more hawkish, but actions will not be there, so RBI’s talk will be worse than its bite," he said.
Other economists said an increase in the CRR at the 27 October meeting is a possibility. Morgan Stanley’s Chetan Ahya puts such a risk at better than 50% as the RBI looks to sterilise capital inflows. Foreign investors have made net purchases of over $13 billion in stocks and bonds so far this year.
But any tightening of reserve requirements would have to be balanced against the need for sufficient market liquidity to ensure the success of the government borrowing programme.
What has the central bank governor said?
In recent weeks, the central bank and the government have had a very public debate over the policy outlook. Governor Duvvuri Subbarao has said the central bank will need to tighten policy earlier than advanced economies, sparking a bond sell off to price in a higher risk of a rate rise.
Still, he has said that timing remains uncertain.
“We may need to exit from accommodative monetary policy earlier than advanced economies. This calls for careful management of trade-offs: growth concerns warrant a delayed exit, but inflation concerns call for an earlier exit," he said at the IMF-World Bank annual meeting in Istanbul last week.
“An early exit on inflation concerns runs the risk of derailing the fragile growth, while a delayed exit may engender inflation expectations."
What has the government said?
Officials including Prime Minister Manmohan Singh and finance minister Pranab Mukherjee have urged caution and stressed the need to promote economic growth.
Indeed, Montek Singh Ahluwalia, the deputy chairman of the government Planning Commission, has said it would be premature to reverse policy before growth hit 7%.
“If the growth rate next year is 7%, then it is reasonable to look at whether you want to change the details of this or that of monetary policy," he said.