Policy Outlook | Dear money

Policy Outlook | Dear money

Every party has to end sometime, especially one kept highly liquid by low interest rates; the beginning of that end could come as early as this month. The Reserve Bank of India (RBI) key policy rate has been 3.25% since April, and roughly Rs1 trillion was sloshing around in the system till recently. With wholesale price-based inflation rising faster than expected (4.78% in November, against 1.34% in October and 0.5% in September) and the momentum of economic growth firmly in place, RBI has little choice but to tighten its monetary policy.

This can be done by hiking its policy rate as well as sucking out excess liquidity by raising banks’ cash reserve ratio (CRR) or the portion of deposits that commercial banks are required to keep with RBI. The key question: Will RBI take one step at a time, or will it launch a two-pronged attack on rates as well as liquidity?

Thus far, the action has been methodical. Last July, RBI signalled the end of a loose money policy but refrained from raising rates or tightening liquidity. In October, the central bank took its first step, closing all refinance windows that had been opened for various sectors to fight the credit crunch in 2008.

Analysts expect inflation to rise to 8% or more by March, largely driven by food prices, against RBI’s projection of 6.5%. Technically, a tight money policy cannot fight the rise in food inflation, but RBI needs to be seen acting to curb inflationary expectations before the situation gets out of hand. A hike in rates as well as CRR is inevitable. RBI could increase both in January, or it may only raise CRR to drain excess liquidity when it announces its quarterly review of monetary policy (or even earlier) and follow with a rate hike in April, after the Union budget. By that time, it will have a clearer picture of the government’s borrowing plans in the next fiscal. (The government borrows from the market to bridge its fiscal deficit, and when money becomes dearer, its cost of borrowing rises.)

We may see a hike of around 1.5 percentage points in policy rates and CRR, phased over 2010. This will push up the interest cost for Indian firms and force banks to shut down the window of 8% home loans.