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RBI action plan to contain inflation

Case for monetary stability in Reserve Bank's third quarter review

Y. V. Reddy

THE DECISION to hike the short-term repo rates by 0.25 percentage point in the Reserve Bank of India's third quarter review of the monetary credit policy might not have been expected. But the central bank has elaborated on the logic behind the move using its customary analyses of the domestic economy as well as global developments to make its central point: ``The overriding importance of maintaining well-anchored inflation expectations is critical for sustaining the growth momentum and ensuring macroeconomic and financial stability."

The main action point, therefore, has been to strike pre-emptively at inflationary expectations by signalling a tighter interest rate regime, at least over the near term.

Choice of monetary tools

The repo rates are now emerging as the most frequently used monetary tools which are essentially liquidity impacting measures and consequently affect the short-term interest rates structure. Including the latest hike, the RBI has increased the repo rates four times since October 2004.

Nowadays leading central banks prefer to concentrate on the short-term demand and supply conditions while framing policies. Monetary tools that are inherently flexible, such as open market operations, have become popular the world over. The introduction of the market stabilisation scheme (MSS) and liquidity adjustment facility (LAF) are all part of the trend.

Besides, traditional monetary tools — the Bank Rate and the cash reserve ratio — could not have been used this time.

The Bank Rate has apparently gone out of fashion as it does not fulfil its role as a benchmark rate. As for the CRR, any reduction at this stage would release substantial funds and indicate that the present demand-supply mismatch will stay longer than what the RBI would like to suggest at this juncture. The reverse repo rate is the rate at which the RBI takes money from banks against securities. The new rate is 5.50 per cent. The repo rate, the rate at which the RBI lends, has been set at 6.50.

At the time of the credit policy's mid-year review there was an identical hike of 0.25 percentage points at both ends of the liquidity adjustment facility (LAF).

The implication for short-term interest rates is this: not only are the new floor and the ceiling rates higher, there is also an expectation that banks will be dealing more at the upper end, suggesting that they are more likely to be borrowers from the RBI than lenders.

Tightening liquidity

Already on the eve of the third quarter review there were reports of extreme tightness in the money markets. The redemption of the India Millennium bonds aggregating $7.1 billion (Rs. 33,000 crore) has been a significant contributing factor.

Many leading banks have been marking up their deposit rates even while contemplating a floor rate on their lending rates. (The last one had more to do with checking the widely prevalent practice of top rated corporate borrowers driving down their borrowing rates). Besides, there were other demand side factors.

Credit has grown significantly in the current year. Non-food credit grew by 32 per cent as on January 6 compared to 26.6 per cent a year ago.

The RBI has said that growth impulses are strong and spread across all the three sectors of the economy. The global economy has been more resilient than perceived earlier.

The disturbing feature, in the RBI's view, is that broad money growth this year is going to overshoot its target of 14.5 per cent. That, combined with factors that have the potential to stoke inflation, has made the RBI act now by signalling a higher interest rate regime.

Although the central bank has raised its GDP growth forecast for this year to 7.5-8 per cent (from 7-7.5 per cent) and maintained its target inflation rate at between 5 and 5.5 per cent, it feels there are enough downside risks that can derail future growth and destabilise the monetary and financial sector.

The persistently high global oil prices pose a major risk to both growth and inflation. There is a growing realisation that a substantial portion of the recent rise is of a permanent nature. For India, there is the added risk of their pass through effect to consumer prices impacting on price stability after a lag. Additionally, the rapid growth in export credit, movement in asset prices and growth in money supply pose risks of potential inflationary pressures.

At a global level, there are uncertainties surrounding currency and interest rate movements besides oil prices. These can impact monetary management in every country. Looking ahead, the RBI feels that it is necessary to frame policies aimed at containing inflation during 2006-07 at or below the 2005-06 level.

Another risk to fiscal stability may arise from the quality of assets that banks have been accumulating recently at a furious rate. Rising asset prices in conditions of abundant liquidity can lead to indebtedness among house- holds.

C. R. L. Narasimhan

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