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RBI’s loud anti-inflation statement

— PHOTO: PTI

INFLATION CHECK: The Reserve Bank of India Governor, Y. V. Reddy (centre), with Deputy Governors V. Leeladhar (left), and Rakesh Mohan announcing the first quarter review of monetary policy in Mumbai last week.

The larger than expected increases last week in the cash reserve ratio (CRR) and repo rate by 0.25 and 0.50 percentage points, respectively, surprised everyone including the stock markets. A more modest hike of, say, 25 basis points in the repo rate (rate at which the RBI lends to banks) was always on the cards. Days before July 29, when the policy review was announced, it was becoming clear that the Reserve Bank of India would very likely mark up the benchmark interest rates.

The RBI Governor had deposed before a parliamentary committee that some additional monetary measures were needed to contain inflation, which at that point was already well into double digits. The Governor’s statement was significant in that the central bank was already in a tightening mode.

Global oil prices had softened and the inflation figure for the week ended July 12 had receded marginally from the previous week’s level. However, even after the recent stiff hike in fuel prices, Indian customers are still insulated from global prices. The expectation that domestic fuel prices will have to go up irrespective of the short-term movements in international crude prices is an important factor underpinning inflation expectations. Inflation for the subsequent week has however moved up to 11.98 per cent.

As recently as in late June, both the CRR and repo rates were hiked by 0.50 percentage point each. Altogether, over the past two months the repo rate has been raised by 1.25 percentage points and the CRR by 0.75 percentage points. By any yardstick, these are loud monetary statements paving the way for higher interest rates and lower liquidity. Yet, few expect the RBI to pause. As long as inflation remains the key macro economic concern there will be no respite for the monetary authorities.

The Reserve Bank does not expect inflation to come down to single digit levels until the last quarter of this year. According to the credit policy, inflation, now in the vicinity of 12 per cent, will have to be brought down to a level close to 7 per cent by next March and to below 5 per cent soon thereafter. The medium term forecast for inflation is 3 per cent. All these are subject to the caveat that there will be no further external shocks, meaning further extraordinary rise in oil prices.

Another factor justifying the current monetary policy stance is the fact that inflation though global is affecting developing countries more than the developed ones. The IMF, among others, has raised its inflation forecasts for developing countries and lowered their growth forecasts.

There is a belief that the RBI has been “behind the curve” in framing its anti-inflation policies. In other words, it should have started the process of monetary tightening earlier. According to this view, it is only with the latest instalment of CRR and repo hikes that the RBI is acting proactively. From that standpoint, the larger than expected hikes are entirely justified, to establish the credibility of monetary policy and to condition inflation expectations.

There is of course a price to be paid. There has been a distinct slowdown in economic growth. The central bank which was seen to be optimistic with its projection of 8.5 per cent GDP growth (for 2008-09) earlier has lowered it to 8 per cent now. Even that seems to be on the high side. Many others have made even lower forecasts. The World Bank estimates the Indian economy to grow by just 7 per cent this year.

The reliance on monetary policy to check demand side pressures has to be seen in a context where the government has practically run out of supply side options. The government had encouraged the import of critical items whose price rise has caused the spurt in inflation. Simultaneously, exports of some of these were discouraged. Supplyside measures also included sharp hikes in the minimum support prices for wheat and rice. But there are limits beyond which supplyside measures will not work.

Monetary measures operate after a lag. Apart from trying to anchor inflationary expectations over the next few months, the hikes in the CRR and repo rates will raise the cost of funding by the banking system immediately. Banks will have to meet their day-to-day liquidity requirements by borrowing from the RBI at the enhanced repo rate of 9 per cent. Meanwhile the CRR hike will drain liquidity and banks’ profitability will further come under strain because they get negligible returns on the impounded CRR balances.

All the above are intended to make lending by banks a costlier proposition. Additionally, the RBI has once again cautioned banks which have been aggressive in their lending.

Past monetary measures have had an impact. Growth in broad money — M3 (aggregate of currency with public, demand and time deposits with banks and other deposits with the RBI) supply has moderated to 20.5 per cent as on July 4, lower than last year’s level of 21.8 per cent. It is the RBI’s intention to bring broad money supply growth rate to its target level of 17 per cent. That depends on the expected deceleration in credit disbursements in the wake of the recent monetary measures.

Looking into the future, it is clear that the RBI will intervene aggressively so long as inflation remains a threat to the macro economy and particularly to the ruling coalition in an election year.

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