Monetary policy evokes renewed interest
The RBI has been trying to balance its two key objectives of maintaining price stability and providing credit for the real sector
— PHOTO: AFP
STEMMING INFLATION:A general view of a bustling market place in Ahmedabad. The Reserve Bank of India raised the short-term interest rates more than expected last week, springing the fifth hike in six months as it tries to tame inflation.
Last week was eventful for the Reserve Bank of India and its monetary policy. The scheduled Mid-quarter Monetary Policy review took place on Thursday. Two days earlier, the Centre announced a new series of Wholesale Price Index (WPI) to measure inflation.
The connection between the two is fairly obvious. The Monetary policy has traditionally been trying to balance its two key objectives of maintaining price stability and providing credit for the real sector. Recently, the focus of the policy has shifted towards controlling inflation at all costs. The new measure, claimed to capture the rate of price rise more accurately, is obviously relevant to the RBI.
New WPI index
The new WPI series has 2004-05 as the base year. The old series had 1993-94 as its base. Altogether, 241 new items have been included in the new series on top of the 435 items whose price rise was being captured by the old index. The extended coverage and a more recent base year, it is claimed, will make the new index more representative in character. For instance, an item that has virtually become a necessary accessory to day-to-day living — the cell phone — was not widely used 15 years ago and hence excluded from the index. The new index will also be able to capture the structural changes that are taking place in the economy. Other improvements over the old series include a greater thrust on uniform data collection. The number of centres from which the data will be sourced has been vastly increased.
Even with the improvements, the new WPI index does not quite capture the changes in the fast growing economy. Services, which contribute more than 50 per cent of the GDP, remain excluded. While the frequency of data dissemination remains the same as it was before — the WPI at monthly intervals and the data on food prices and other articles at weekly intervals — there is a clamour for moving towards the international practice of having a representative Consumer Price Index for policy purposes.
The new index showed that inflation in August declined by 1.3 percentage points to a seven month low of 8.5 per cent. However, going by the old index, which will still continue to be published, inflation dipped only marginally to 9.5 per cent in August from 10 per cent in July. The new method probably makes the data more accurate as well as up-to-date but does not hide the fact that inflation remains high in absolute terms.
The Mid-quarter Monetary Policy is a recent innovation of the RBI. In the July quarterly statement, while announcing the decision, the RBI said that it was formalising a procedure that was happening anyway. The point is that in a highly fluid economic situation, the central bank needed to intervene and communicate with the markets more frequently than it has been used to. Such interventions, insofar as they happened outside the dates of policy statements, no doubt had the surprise element in its favour. However, too frequent and unscheduled monetary interventions were probably counterproductive. Hence, in keeping with the practice of major central banks, it was decided to increase the frequency of policy statements from four to eight. Not long ago there were only two statements. The increase in the number certainly says a lot about the challenges the RBI faces.
Hike in key rates
Being the first is not the only attribute of the three-page easy-to-read mid-quarter review. It has details of the monetary measures in its opening paragraph itself. Lest anyone complain that the surprise element in monetary policy is being eschewed, the RBI hiked the repo and reverse repo rates in an asymmetrical manner. The repo rate was increased by 25 basis points. If that was expected, the hike in the reverse repo by 50 basis points was unexpected. The new repo and reverse repo rates are at 6 and 5 per cent, respectively. The range between the two is narrowed and should theoretically reduce volatility in the money market. A more nuanced view of the changes in the policy rates is something like this. The reverse repo is the rate at which RBI pays banks for the funds deposited.
So, a sharp hike suggests that banks will have a greater incentive to deposit surplus funds with the RBI. But there is no surfeit of liquidity at present. Deposit growth and credit offtake have been below par. The current account has widened, partly because foreign inflows have moderated. In such a situation, it is the repo rate, the rate at which the RBI lends, that will continue to be the benchmark. Hence, banks will heed the signal and mark up their lending rates. In any case, deposit rates are already going up as banks experience difficulty in mobilising deposits.
Inflation remains the dominant concern. According to the new and old series, the inflation, as stated above, is well above the RBI's target range of 6 per cent for the year. But the unexpectedly large hikes suggest that the RBI will no longer be behind the curve. Besides, the latest economic data have been good. In the first quarter, the economy grew by 8.8 per cent and the Index of Industrial Production jumped to 13.8 per cent in July. The strong growth gives an opportunity to hike interest rates. What about the future? The RBI has indicated that since ‘normalisation' has been reached and with inflation reaching a plateau, monetary policy will, henceforth, be guided by the overall macro economic consideration. Inflation will, however, be under close and constant scrutiny.
C. R. L. NARASIMHAN
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