A large section of economists, analysts and bond dealers is rooting for status quo in the mid-year review of monetary policy by the Reserve Bank of India (RBI) on Tuesday. This section argues that it’s time for the central bank to hit the pause button because its rate tightening cycle, which started in March, is showing results.

Between March and September, RBI raised its repo rate, or the rate at which it lends money to banks, by 125 basis points (bps) to 6% in phases. One basis point is one-hundredth of a percentage point. RBI also raised its reverse repo rate, or the rate at which it sucks out liquidity from the system, by 175 bps to 5%, besides hiking the cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank, by 100 bps to 6%. The combination of these actions has made money more expensive, both in the long and short terms. The yield on 10-year government bonds is now around 8.15%; the short-term three-month commercial paper costs around 8% for a top-rated manufacturer and 8.25% for a non-banking finance company.

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The lobby seeking status quo received a shot in the arm last week when the interbank call money rate rose to 12% and cash-starved banks borrowed Rs1.18 trillion from RBI, the highest in two years. The central bank had to step in to cool the market by opening a second window for liquidity injection and allowing banks to maintain less investment in government bonds in the form of statutory liquidity ratio, or SLR, for a day. Banks are required to invest 25% of deposits in government bonds, but RBI allowed this to dip to 24%. Theoretically, such a measure allows banks to borrow more from RBI as they need to offer bonds as collateral to borrow money from its repo window. Had there been no such relaxation, banks who didn’t have excess investment in government bonds wouldn’t have been able to borrow from the regulator. When the system runs in a deficit mode, the cost of money automatically goes up and there is no need to increase interest rates, argue those in favour of a pause in the tightening cycle.

Indeed, the system will remain cash-starved as no big-ticket redemption of bonds is likely to happen soon. The government is slated to raise Rs1.59 trillion from the market in the second half of the fiscal, and on top of that at least another Rs30,000 crore will be drained from the system through share sales by public sector firms at periodic intervals. The cash crunch will intensify in mid-December, when around Rs45,000 crore will go out of the system with firms paying advance tax on their estimated profit for the third quarter of this fiscal.

There are other equally potent arguments against a rate hike. The momentum in industrial production is slowing; export growth is tapering off; the HSBC Markit Purchasing Managers’ Index data show softness and, above all, inflation is on a downward trajectory. Factory output growth dropped sharply to 5.6% in August, from 15.2% in July, and the Purchasing Managers’ Index, a leading indicator of manufacturing output, was at its lowest level for the year in September for most economies, including India and China. There was also a slowdown in cargo handled by ports and railway goods traffic growth in July and August. While all these indicators signal that the investment cycle has not picked up as yet, the drop in wholesale price-based inflation in September to 8.6% from a high of 11% in April is encouraging many economists and analysts to oppose a rate hike.

The seasonally adjusted data show that inflation in non-food manufactured goods, or so-called core inflation, eased to 5% in September from 6% in April. A good monsoon has ensured that food inflation will decline in the next two months with the harvest hitting the market. Indeed, global commodity prices remain a risk, but an appreciating rupee can take care of that; when the local currency rises, the cost of imports goes down.

Finally, the US Federal Reserve’s impending second phase of quantitative easing, due immediately after the RBI policy is unveiled, is being cited as a big negative for any rate hike in India as higher interest rates will widen the rate differential between India and the US and attract more capital inflows.

All these arguments are fine, but I would still stick my neck out and say it’s too early to press the pause button as inflation remains unacceptably high. Pausing at this moment will confuse the markets and make RBI’s stance inconsistent, though it doesn’t mean the end of the rate tightening cycle. Real interest rates in India are still negative and lower than in other emerging markets. In that sense, monetary conditions continue to be accommodative and RBI must hike its key policy rates by 25 bps each to make money more expensive and dampen excess domestic demand. Inflationary expectations need to be curbed and that can be done by hiking rates. RBI also should not give the impression that it’s the end of the rate-tightening cycle even as it remains sensitive to macroeconomic developments.

RBI also needs to have a strategy in place to tackle the liquidity crunch in the system as too much of a deficit for too long a period can create problems. One way of tackling this is infusion of money through a cut in CRR, but that is ruled out as a rate hike and a cut in CRR cannot go hand in hand. Any reduction in the government’s borrowing programme will also bring comfort to the system, but that too is unlikely. So RBI needs to buy back government bonds in a measured way to infuse liquidity. If it starts buying dollars from the market to check the appreciation of the rupee, that too will add to liquidity because for every dollar RBI buys from the market, an equivalent amount in rupees gets into the system. It will, of course, depend on the volume of foreign capital flows. For the time being, neither the government nor RBI is complaining about capital inflows as it is financing the country’s current account deficit.

Freeing savings rate

As the 2 November policy is a mid-year review, one would expect RBI to go beyond rates and take stock of other significant policy initiatives such as freeing the savings bank rate and offering larger play to foreign banks. I am told that the draft policy on foreign banks’ role in India, which the regulator had promised to release by September, is still with the government.

RBI has been taking about the pros and cons of freeing the savings bank rate, but doesn’t seem to be ready yet to bite the bullet. This is an anomaly in a financial system where all loan rates and about 70% of the industry’s liability rates are free. I would not be surprised if RBI takes yet another baby-step towards freeing the savings bank rate by constituting a committee to look into the subject.

Finally, it should not keep its eyes shut forever to the booming mortgage market. Banks and housing finance firms continue to deny the benefit of floating rate loans to their existing customers and offer teaser loan schemes to woo new customers. Teaser loans try to entice borrowers by offering an artificially low rate at the initial stage; the loan rate increases after a few years. Usha Thorat, the outgoing deputy governor and some of her colleagues, have been vocal about such teaser loan schemes, but there has been no action by the regulator on this. Thorat retires next week and it will be nice if the policy document shows that the regulator is sensitive to what’s happening in the mortgage market.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to bankerstrust@livemint.com