Time for RBI to raise rates1 min read . Updated: 27 Jan 2010, 08:28 PM IST
Time for RBI to raise rates
There must be great pressure on Reserve Bank of India (RBI) governor D. Subbarao to not increase interest rates in the monetary policy he is due to announce on Friday, but we think it is time for him to bite the bullet.
Subbarao slashed interest rates between October 2008 and April 2009 as part of a coordinated strategy with the finance ministry to keep economic activity on course in the midst of the worst global downturn since the 1930s. The ministry cut taxes and increased spending as part of the same effort, leading to the widest fiscal deficit in more than a decade.
The consensus view is that Subbarao should for now limit his actions to soaking up excess liquidity from the money market with a 50 basis points increase in the cash reserve ratio of banks. And that he should wait till the Union Budget is announced on 26 February to see the extent of fiscal correction the government will effect this year.
This is a credible argument but does not take into account the steep rise in inflation in recent months, which increases the probability of double-digit inflation by the middle of this calendar year, far more than RBI’s year-end estimate of 6.5% with an upward bias. Food prices are a big part of this resurgent inflation but there are also early signs of rising prices of manufactured goods. The choice before Subbarao is to go in for a small 25 bps hike in the repo and reverse repo rates on Friday —or hold his fire, only to rattle the markets with larger interest rate increases in the next few months. We think the first option the better one at this juncture.
Indian policy interest rates are almost 4 percentage points lower than what they were before they were cut to stabilize the economy. Rates have to get back to normal levels as the economy returns to normal. Even covering half that distance in the next 12 months will entail an upward movement of 200 bps. It is better to space out these increases beginning Friday rather than give the economy sudden jolts.
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