RBI inches closer to a neutral rate

RBI inches closer to a neutral rate

The Reserve Bank of India (RBI) is breathing much easier before Thursday’s monetary review than it possibly has in the past two years. Inflation has started moderating and economic growth has stabilized on a broadened base. With a clearer path between these two objectives, of combating inflation and promoting growth, the central bank will continue to inch closer to a more neutral rate in another baby step.

There is little to suggest a pause at this point. Nominal growth rates are high and real interest rates—discounting for inflation—are still negative. Policy rates need to reflect economic reality, a fact that RBI stated bluntly in its July monetary policy review.

On a seasonally adjusted basis, the three-month moving average of the Wholesale Price Index (month-on-month, or m-o-m, percentage change) has shown a downward trend for eight consecutive months. This momentum will most likely sustain in the near term, as food supplies ease. Core inflationary pressures are, however, expected to increase in tandem with robust economic activity. Assuming these to be 6% or thereabout, RBI would like to align the repo rate—the rate at which banks borrow from it—with a 0.25 percentage point increase right now, rather than wait until October when it is likely to pause.

There is little likelihood of growth being affected by this move: Policy rates will still remain pro-growth, as consumer demand will stay upbeat in the festival season ahead. The interest rate-sensitive segments, such as automobiles, have not yet responded to the previous hikes: Car sales continue to be buoyant, while supply constraints are currently pushing producers towards capacity expansion over the next two-three years. But the subdued growth in consumer non-durables indicates that the pinch of the price rise is being felt most by the income-sensitive component of the population. That’s why policy rates need to keep up with inflation rates.

Like non-durables, monetary aggregates too continue to be adversely influenced by rising prices. Deposit growth is very low—below 15%, year-on-year—indicating that high inflation is eroding the real return on bank savings, and discouraging people from keeping money in banks; this despite the fact that the demand for holding cash is slowing, with deposit rates actually rising in August. Returns on savings need to rise further to stimulate broad money growth that is significantly below the projected 17%. However, the seasonally adjusted, m-o-m growth in non-food credit (taking an annualized, three-month moving average) has been in the 20-32% range since January. This will surely touch the upper bound as private sector borrowing picks up in the forthcoming busy season, stretching the funding capacity of banks, which are already lending 72% of their deposits. The gap between deposit growth and loan growth thus needs to narrow.

Interest rates matter for India’s external balance as well. The widening current account deficit, for instance, now warrants greater attention. Though financing it should not be a problem, RBI needs to keep a watchful eye and be ready with short-term macroeconomic responses. In the event of a worsening global scenario, for instance, RBI’s typical first-round response is to encourage inflows by tinkering with the variable components of the capital account, for instance, residents’ borrowings abroad or foreign-held, domestic debt. In a different scenario—the rise in foreign borrowings by firms in the past two quarters already reflects an improvement in the fund-raising environment abroad—a wider domestic-foreign interest rate gap would provide the right incentives for these inflows without raising caps at this stage.

A recent development makes a symmetric hike in policy rates a close call. With the appointment of a committee this week to examine the liquidity adjustment facility (LAF)—the very method by which RBI conducts its monetary policy—the central bank may want to wait for its recommendations before any further moves. However, RBI governor D. Subbarao has clearly said that a “zero-width corridor (between the two policy rates) is a distinct possibility in the future". Depending on the time span of a possible change—the committee may recommend switching over to a single policy rate—RBI may continue narrowing the corridor in small steps as it experiments and gives market participants time to adjust. If RBI chooses this very option, the corridor could be narrowed on 16 September to one percentage point, with a 0.50% hike in the reverse repo rate (the rate banks get when they park excess funds with RBI). The corridor now stands at 1.5 percentage points.

That said, the choice to eliminate the corridor is an interesting development. Recall that former governor Y.V. Reddy had steadily widened the fluctuation band from 1 percentage point in October 2006 to 3 percentage points by July 2008, imposing a quantitative limit of 3,000 crore on LAF deposits in 2007 to discourage a carry trade—borrowing at low rates abroad and investing at higher ones with RBI—at the peak of global liquidity. Post-crisis, the LAF corridor has been narrowed consistently and looks set to be completely eliminated in due course, an attempt to improve the transmission of monetary policy signals. It remains to be seen, though, whether a single rate can influence money markets smoothly.

Renu Kohli is an economist and a former staff member at the International Monetary Fund and RBI.