Same policy rate, but the economic environment is different

Same policy rate, but the economic environment is different

With the central bank governor saying he’s desperate to control inflation, the Reserve Bank of India (RBI) raising its policy rate on Tuesday is a no-brainer.

Also See| Then And Now (Graphic )

The repo rate, or the rate at which banks borrow overnight money from RBI, is currently at 6.25%. The last time it was at 6.25%, during the upward swing of the cycle (not on its way down), was in 2005-06, when it was raised to that level on 26 October 2005.

The average wholesale price inflation in that fiscal year was a lowly 4.4%. Contrast the current average of around 9% for the last nine months, and monetary policy does seem excessively loose.

But GDP growth in 2005-06 was 9.5%, on top of 7.5% growth in 2004-05. In fiscal 2010-11, GDP growth is expected to be lower, at around 8.5%, after growth of 7.4% in 2009-10.

The problem is that although growth is lower, inflation is higher and while tightening the screws on monetary policy will bring down inflation, it will pull down growth further.

Also, bank interest rates are higher now. Interest rates on bank deposits for one-three years ranged between 6% and 6.5% in 2005-06. Currently, at State Bank of India, this range is 8.25% to 9%. Higher deposit rates imply higher lending rates.

Worse, investment demand was more robust in 2005-06, when gross fixed capital formation growth was 17.6% on top of 18.9% growth in the previous year. In the first half of 2010-11, gross fixed capital formation grew by 16.3% after increasing just 7.1% in 2009-10. High interest rates could affect capital expansion plans.

Also, an issue is very tight liquidity, which is partly the result of the cash reserve ratio being at 6%. It was 5% in 2005-06. On 24 January 2006, the repo rate was raised to 6.5% and the reverse repo rate to 5.5%. RBI may do the same on Tuesday, but the economic environment is very different.

Graphic by Naveen Kumar Saini/Mint