ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Interest Rate Hike: Dictates of Caution

Dictates of Caution There are few surprises in the Reserve Bank of India


Dictates of Caution

here are few surprises in the Reserve Bank of India’s first quarter review of the monetary policy for 2006-07. The markets had largely expected a further hike in rates and even the union finance minister, P Chidambaram, had gone as far as to suggest that a rate hike would not materially affect the economy. In the event, as everyone expected, the reverse repo rate has been increased by 25 basis points from 5.75 per cent to 6 per cent and the repo as well, which will now stand at 7 per cent. The RBI has made a persuasive case for the rate increase and it is indeed unlikely that the corporates in the organised sector (which in any case largely obtain their funds at below the prime lending rate) will go slow on their investment plans. However, what will be cause for concern is how the series of rate hikes going back to late 2004 are going to affect the small and medium enterprises, which remain dependant on the banking sector for their short- and long-term finance.

Among the domestic factors driving the argument for a modest hike in interest rates two stand out: monetary aggregates are indicative of incipient over-heating of the economy and inflationary tendencies remain under the surface. The year-on-year (y-o-y) growth monetary trends leave no room for ambiguity: Broad money supply (M3) has grown by 18.8 per cent, substantially more than the 13.8 per cent growth a year earlier and the 15 per cent growth indicated in the RBI’s annual policy for 2006-07. Non-food credit has increased by as much as 32.9 per cent over the past year, as against a 31 per cent increase the previous year. This credit growth has been concentrated in the service sector: retail lending has risen by 74 per cent, housing by 115 per cent and commercial real estate lending by 101 per cent. On the other hand, credit growth to industry on a y-o-y basis has been only 26 per cent.

The trends in inflation are more ambivalent. On a pointto-point basis, the annual rate of wholesale price inflation has modestly accelerated from 4.1 per cent to 4.7 per cent between end-March and early July. On an annual average basis – the more appropriate measure for comparison – inflation is running now at 4.3 per cent, a marked slow down compared to 6.3 per cent a year ago. Yet, consumer price inflation on a y-o-y comparison shows a sharp acceleration for all categories of income earning groups. In the end, it is expectations of the future course of inflation that should influence policy and here the signs are not very positive. Global crude oil prices are touching new highs and this may soon call for yet another domestic adjustment. International prices of primary commodities too are now hardening and at home as well some primary articles are showing a surge in prices.

To maintain inflation in the range of 5 to 5.5 per cent in a year when the central bank expects growth to be in the range of 7.5 to 8 per cent, the RBI has chosen the path of caution. It is clear that the RBI has also been strongly influenced by global developments, which, in spite of the “repricing of risk” in some markets, suggest “marked downside risks”. The global scenario is one in which an overwhelming number of advanced and developing economies have in recent months increased interest rates. With the RBI clearly giving as much importance to international as to domestic factors in formulating policy, there was little doubt that it would choose to increase rates less than three months after the last hike.

Can one be optimistic that growth in the industrial and service sectors will remain unaffected by the interest rate increases? True, capital goods output has surged strongly in the first two months of the financial year 2006-07 and business confidence remains high. However, with banks and markets making allround increases in interest rates there must be some question mark over how the slow but continuous rate revisions in the upward direction will have an impact on the economy’s growth prospects. The choice is clear when it is a question of choosing between moderating growth and letting inflation get out of hand. But the real question to ask is if the risk of inflation is really very strong or if the RBI is being ultra cautious about inflationary pressures in the economy.


Economic and Political Weekly July 29, 2006

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