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Thursday, May 27, 2004

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INTEREST RATES AND INFLATION

OF ALL MACROECONOMIC variables, the one most discussed by policymakers and laypersons alike is the interest rate. Linking several segments of the domestic economy, interest rates have a major influence on that critical and visible component of the external sector, the country's exchange rate policy. In an increasingly globalising world, a country's interest rate policy has come to depend significantly on the interest rate stance of other countries, especially those with whom it has strong trade and non-trade relationships. Over the past three years, domestic interest rates have been brought down substantially, a development attributed to the ongoing financial sector reform process. Despite that, interest rates in the country are higher than in the developed world. The interest differential in favour of India is one of the reasons the country's reserves have grown at such a fast clip. During the same period, the cost of bank credit has come down substantially, matching the fall in the general level of interest rates. Banks have marked down their prime lending rates by more than 3 percentage points compared with three years ago. Yet the increase in credit offtake has not been commensurate with the reduced interest rate levels. This suggests that the institutional mechanism for credit delivery needs to be looked into along with the structural rigidities inhibiting a further reduction in the cost of bank credit.

The debate over the future direction of interest rates has been of perennial interest. Right now it has a certain contextual significance. On May 18, the Reserve Bank of India unveiled its monetary and credit policy for 2004-05.The central bank's stance on interest rates is closely linked to its view on inflation expectations. For the record, the RBI reiterates its commitment to a softer interest rate regime. Emphasising the need to consolidate the gains obtained from reining in inflationary expectations, it says that all the good work that has helped to build confidence in price stability can come to nought in a remarkably short time. For inflationary expectations can turn adverse in a relatively short time if noticeable adverse movements in prices take place. The pointed reference here is to the prevailing high oil prices. The new Government has the unenviable task of shifting the burden from the public sector oil companies to consumers. Whatever be the quantum of increase in the domestic fuel prices, inflationary expectations are bound to go up, considering that the stickiness of the prices of oil and other commodities in global markets is not expected to disappear soon. Besides, persistent excess liquidity in the domestic markets can stoke inflationary expectations over time. For these reasons the RBI expects the inflation rate to be around 5 per cent during 2004-05. Right now it is around 4.2 per cent.

What is more, in the United States and other developed countries, interest rates are poised to go up. It may not be long before Indian interest rates follow suit. Another way of looking at interest rates is from the point of savers, a neglected lot. Interest rate discussions in this country have tended to be one-dimensional, taking into account borrower concerns alone. Sadly, certain categories of savers such as pensioners are already getting negative returns. The nominal returns from safe investment avenues such as bank deposits do not even cover inflation. Other investment avenues such as the share market, mutual funds and even non-banking finance companies have become risky. In a country where social security exists only for a very small segment of the population, inflation-related concerns affect ordinary people most of all.

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