Ensuring policy transmission

Ensuring policy transmission

Having hiked policy rates by 25 basis points (bps) in early July, the Reserve Bank of India (RBI) was widely anticipated to hike rates by another 25 bps. In the event, RBI’s decision to narrow the interest rate corridor was a surprise, but it is a welcome move. The most important change in this policy is RBI’s objective that liquidity will “remain broadly in balance" which has ensured that the repo will be the operative rate, going forward. RBI has used the current opportunity of tight liquidity conditions to ensure a more effective transmission of policy rates to bank deposit and lending rates. Since the trough, RBI has now raised the repo rate by 100 bps and reverse repo by 125 bps.

There are three key questions that need to be addressed: First, do we need more rate hikes? Second, do rate hikes have to be as aggressive as they have been so far? And third, what does RBI’s liquidity stance suggest?

As things stand today, there is still no reason for RBI to change its course. The economy has moved from a recovery to an expansion mode. And inflationary concerns have reached a crescendo. Gross domestic product (GDP) growth, excluding agriculture, which was weighed down by the drought, has rebounded to 10% year-on-year (y-o-y) in the first quarter of 2010, the highest in two years, and the second quarter is likely to register another 8.5%-plus GDP growth.

Inflation, meanwhile, has become entrenched. Demand-side inflation due to lack of enough capacity and lagged effects of higher food and fuel prices is likely to keep core inflation elevated. Therefore, even as base effects moderate headline inflation in the coming months, RBI cannot take comfort and needs to continue to tighten monetary policy.

However, the pace of policy tightening can be tempered, compared with the 100-125 bps rate hikes delivered since March. Policy rates are much closer to neutral today than they were six months back. And remember: monetary policy operates with long and variable lags. Globally, commodity prices have eased a bit from the April levels, which bodes well for input cost pressures. Crop area sown is progressing well. This portends good news in the future for core inflation. Moreover, recent data from the advanced economies points to a much weaker second half. Even though India’s final demand remains strong, it is not immune. Indeed, lead indicators are pointing to some moderation in industrial output growth in the second half of 2010.

Tight liquidity conditions could not have come at a better time for RBI. But its objective of ensuring that liquidity remains broadly in balance will be difficult to implement. While it didn’t take long for Rs1 trillion to flow out after the spectrum auctions, it is difficult for the government to spend this quickly. Other seasonal liquidity outflows such as advance tax payments in mid-September and higher currency in circulation ahead of the festive season in October can delay the return of liquidity. Moreover, this liquidity tightness is getting exacerbated for a structural reason. While RBI’s domestic assets are still rising, they are being partially offset by declining net foreign assets due to India’s high current account deficit and a lower money multiplier due to the cash reserve ratio hikes. Ultimately, lack of enough investments is the primary reason for high inflation. The answer lies in encouraging investments. There is no doubt that policy rates have to move up, but persistent tight liquidity conditions can reduce the availability of credit and nip the growth bud just as it has moved into an expansion phase.

Sonal Varma is vice-president and India economist, Nomura Financial Advisory and Securities (India) Ltd. The views expressed here are her own.

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