By Jayachandran/Mint

By Jayachandran/Mint

Ourview | Another rate hike is required

Ourview | Another rate hike is required

Reserve Bank of India (RBI) governor D. Subbarao has to make one of his toughest calls on Friday, when he is due to decide on the future course of interest rates.

Data released this week shows that there are growing signs of slowing economic activity, but the unrelenting pressure from inflation has not gone away. Meanwhile, global economic conditions have deteriorated in recent weeks, with growth slowing in China and the European sovereign debt crisis worsening.

So should Subbarao pause or go for yet another rate hike?

The Indian central bank has indicated earlier this year that its key concern continues to be inflation control. Inflation in August was at its highest level in 13 months.

News Report

Aug inflation accelerates; rate hike seen

The inflation expectations of households have climbed to over 13% and Subbarao had hinted six weeks ago about the risk of a wage-price spiral forming. In other words, high inflation is getting embedded in the Indian economy.

By Jayachandran/Mint

The pressure is already building up on RBI to hold its fire on Friday. Finance minister Pranab Mukherjee, his chief economic adviser Kaushik Basu and Planning Commission deputy chairman Montek Singh Ahluwalia have all separately indicated that Subbarao should not increase the policy rate on Friday. The money markets have been pricing in lower interest rates as well. The one-year overnight indexed swaps are lower than the current repo rate and the yield curve for government securities has inverted, with the yield on five-year bonds lower than that for one-year bonds.

We believe that Subbarao should go ahead with one more rate hike of 25 basis points this week, and then watch three parameters before making his next move: whether the European sovereign debt crisis worsens, whether a global recession takes pressure off commodity prices and whether corporate margins shrink in the current fiscal year. The domestic growth slowdown right now is still a mild one.

Meanwhile, the government should do its bit for the anti-inflation battle, by preventing any further increase in the fiscal deficit. The budgetary gap is almost sure to cross its target this fiscal. An inflation-ridden economy could do without this additional effective demand.

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