The Hindu : Business : Balancing inflation and growth objectives

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Monday, Jun 20, 2005

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Balancing inflation and growth objectives

An upturn in interest rates will certainly burden the Government with high cost of borrowing

The recent fear of inflation largely arises from the persistent rise in world oil prices.

WITH world oil prices continuing to reign on the higher side with a wide band of uncertainty, an upward revision of fuel prices in India has become inescapable. The Prime Minister, Manmohan Singh, has conveyed to his leftist partners that there is no alternative to a hike in prices of petrol and diesel due to mounting losses of state-owned oil companies. Such a revision will definitely hurt consumers. Price stability being an objective of the Reserve Bank of India, fuel price revision is a major source of worry for the RBI Governor. Foreseeing an upward pressure on domestic prices, Y. V. Reddy announced, in the Annual Policy for 2005-06, a 25 basis points hike in the fixed reverse repo rates while maintaining other key policy parameters as set out in the Mid-term Monetary Policy Review of October 2004. What does this policy stand convey?

The fixed repo and reverse repo rates are used as policy instruments for day-to-day liquidity management under the Liquidity Adjustment Facility (LAF). The fixed repo rate is the rate at which the RBI lends to commercial banks whereas fixed reverse repo rate is the rate at which the RBI borrows from commercial banks.

Thus, the fixed repo operation is to inject liquidity into the market while the reverse repo operation seeks to suck out liquidity from the market. So, the official hike in fixed reverse repo rate signals that the RBI wants to tighten liquidity in the market believing that it will help in controlling the expected inflation.

Adequate liquidity

Besides, the RBI continues to ensure appropriate liquidity in the system. This could be the reason why the other key policy parameters — CRR and Bank Rate — have been left untouched. Assuring adequate liquidity is stressed in the context of maintaining benign interest rates as it would help sustain the growth momentum. The Finance Minister too justified the hike in the reverse repo rate. He is of the opinion that this is unlikely to put any upward pressure on bank lending rates thanks to the ample liquidity in the system. In that sense, the repo rate hike may not slow down the ongoing industrial recovery, and sends only a signal to keep inflation under control. Altogether, the policy stance indicates that being at ease may trigger inflation and being too tight may set the industrial recovery in reverse gear. There are two crucial questions that appear on the screen in the above background. First, whether this rate hike will nip any inflation expectation in the bud without choking the industrial recovery? Second, is it any more possible to live with benign interest rates?

The direction and strength of the impact on inflation expectations from an interest rate hike will depend upon what lies behind the expectation.

The recent fear of inflation largely arises from the persistent rise in world oil prices. Though the inflation rate is projected to be within the desirable range of 5-5.5 per cent for 2005-06 it is rational to expect a higher inflation for a variety of reasons. The impact of increased oil price is yet to be passed on to domestic consumers and the chances of deferring a price revision are low.

Supply shocks

However, inflation due to supply shocks leaves a hard choice for the monetary authority, as any policy reaction will result in output loss. Supply shocks, particularly followed by a spike in oil prices, can put the growth process in reverse gear, as it will push aggregate demand down and stoke cost-push inflation. Unfortunately, monetary policy cannot combat both recession and inflation at the same time. Any attempt to reduce inflationary pressures by engineering a hike in interest rates may exacerbate economic slowdown.

History reminds us that the recessions in 1973 and 1981 were the consequence of a sharp increase in interest rates by central banks to fight the inflationary impact of increased oil prices. Further, the output loss tends to be on the higher side when the rise in oil prices is highly volatile as observed in recent times. Even if policy remains passive to inflationary pressures, output loss due to increased oil prices seems inevitable. In response to rising prices, oil product use fell 5.3 per cent while import of crude oil declined 2.9 per cent in April this year. If central banks, on the other hand, focus on such demand reducing effect of the rise in prices and ease the policy to stimulate growth it may add fuel to the inflation. Given the situation, monetary policy has a dual mandate of reducing inflationary pressures and stabilising growth, but conversely both factors pull the policy in opposite directions. This is the dilemma for the RBI Governor while formulating the Annual Policy for 2005-06.

Impact on market rates

What is the implication of the 25 basis point repo rate hike on interest rates in the market? Will it not come in the way of maintaining benign interest rates that enable the economy to remain in the recovery mode? The answer is not in the affirmative. Whenever there was a rise in the policy rate the market did react to it. When a 25 basis hike in reverse repo rate was announced in the Mid-term Monetary Policy Review of October 2004, the commercial banks' deposit and lending rates did rise, despite ample liquidity in the system. But, the current scenario is entirely different. Even if there is no hike in the policy rate, the market rates will tend to ascend. Hence, the impact on market rates of a rise in reverse repo rate gets magnified. The private and foreign banks are already set to hike both lending and deposit rates. There are diverse reasons against interest rates remaining benign. For instance, there is a fall in deposit growth and banks have already placed their plea with the RBI to free deposit rates.

Non-food credit has registered a phenomenal growth due to the industrial recovery. The Government has planned a larger borrowing of Rs. 83,000 crores in the first half of this financial year.

In fact, a bi-directional cause and effect relation has already set in between expected inflation and nominal interest rates. There are factors that remain outside the control of the RBI to put upward pressure on interest rates.

Therefore, a rise in nominal interest rates seems unavoidable even if the policy remains passive to expected inflation. This may not affect the ongoing industrial recovery provided the return on investment rises more than the increase in interest rates. Besides, the upturn in interest rates will certainly burden the Government with high cost borrowing, which will create more hurdles on the road to fiscal rectitude and result in further slippages of fiscal targets mandated in the already diluted FRBM Act.

M. RAMACHANDRAN

(RBI Chair Professor, Institute for Social and Economic Change, Bangalore. He can be contacted at: ramachandran@isec.ac.in)

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