Have interest rates peaked?

Have interest rates peaked?

The Reserve Bank of India (RBI) has increased its key policy rate for the twelfth time since March 2010.

It is now worth asking: Is the Indian central bank near the end of its tightening cycle? Have Indian interest rates peaked? One way to answer these questions is to compare the current bout of high inflation with the one we saw in 2008.

• • •

News Report

RBI hikes repo rate by 25 bps to 8.25%

• • •

The rate at which the RBI lends overnight money to commercial banks is now 8.25% -- or still 75 basis points below its peak level in September 2008. That was when the central bank led by Y.V. Reddy was battling double-digit inflation and just days before the collapse of US investment bank Lehman Brothers sent the world economy into a tailspin.

The inflation episode of 2008 was shorter than now even though the peak inflation rate was far higher. In 2008, we saw seven consecutive months of 8%-plus inflation. Till August 2011, India has had 20 consecutive months of such high inflation this time around. The highest point of the 2008 inflation curve was reached in July, when inflation peaked at 11.15%. The highest inflation this time around was the 10.88% in April 2010.

The data shows that the inflation that India is experiencing right now is more deep-rooted and generalized. As a result, there are signs that economic agents have lost confidence in the ability of the authorities to control prices. Inflation expectations of households, which the central bank surveys every quarter, are running far higher than the actual inflation rate, and could eventually create to a noxious wage-price spiral.

The RBI has once again reiterated its view that inflation will begin to decline in the second half of this fiscal year. However, it has also said in its statement: “… with the likelihood of inflation remaining high for the next few months, rising inflation expectations remain a key risk".

So, despite signs of slower economic growth and a gradual decline in inflation, the Indian central bank may have to keep pushing up interest rates before it regains its credibility and brings down the inflation expectations of households.

The case for an end to the rate-hiking cycle is growing stronger by the day, but getting inflation expectations back into safe territory may lead to tougher action. Unless there is a huge global shock or a sudden collapse in the Indian economy, interest rates could inch up further in the coming months.