What should the Reserve Bank do in the upcoming review of monetary policy, given the deceleration in industrial growth, credit growth and export growth on the one hand and stubbornly high inflation rate in the range of 10 per cent on the other? While one section of industry has called for a course reversal, a section of the intelligentsia has argued for a pause and still another group an increase in policy rates to bring down inflation.
In the face of elevated inflationary expectations, supply constraints and a built-in demand momentum, inflation has persisted in the range of 9.5 per cent since December 2010. Further, the reported headline numbers remain much above the threshold of 6 per cent, estimated by RBI studies. Hence, there is little scope for a policy reversal at this juncture. The choice for RBI is whether it should go for a pause, given the conditions of global uncertainty emanating from US and Europe, or inflict another rate hike. The arguments against rate hikes are based on the premise that monetary policy works its way through the economic system with a lag, and that we should give it some time to work its way through the system. The upward bias of the policy rate in the current cycle has continued for 19 months, during which repo rate has been raised on 12 occasions by 350 bps from 4.75 per cent to 8.25 per cent. In the previous run of monetary tightening, the repo rate was raised on 10 occasions from October 2005 to July 2008, and by 300 bps.
While it is true that the current run of rate increases surpasses the earlier period in terms of number of rate hikes and the increase in interest rates, the duration of the previous tightening cycle was close to three years, whereas we are only about 20 months into the current tightening phase.
COMPARISON WITH PAST
Further, in the previous cycles, the repo rate was raised by RBI to cool a seemingly overheated economy and risk weights and provisioning norms were raised to prevent build-up of a bubble in the real estate sector. In the present tightening cycle, monetary policy not only seeks to curb demand but also inflationary expectations, which are deeply entrenched. The additional challenge before RBI is not the building up of an asset price bubble, but the need to be prepared for a possible global recession.
Policymaking in such a context should prepare for all possible situations. This is a moment of flux in the global economy — it can go either way from the current situation. If US goes for another dose of quantitative easing, any kind of soft posturing on the inflation front will make it difficult to curb inflationary expectations.
If the situation in Europe worsens and political brinkmanship continues in the US without any affirmative policy action, RBI will have greater manoeuvrability in relaxing rates, if were to raise the rates further. Therefore, a rate hike now is not without merit.
If RBI is to increase the repo rate, the next question would be by how much? An observer of the RBI's policy would notice that RBI follows a practice of altering policy rates by 25 bps or a multiple of it either on the upside or downside. Should RBI go for another 25 bps hike in the repo rate in the present instance?
Not necessarily. Following an increase in policy rates by 350 bps, commercial banks have raised their base rates in the range of 30-40 per cent in the past one year. The sharp increase in interest costs is already affecting the interest service coverage ratio of fringe companies. Companies have fallen back on their internal resources to absorb the increase in interest cost. However, there are limits to such absorption.
COLLATERAL DAMAGE
If RBI goes for a 25 bps hike in repo rate, banks will be forced to pass it on to customers. The additional interest burden can cause substantial collateral damage to the economy in the form of higher NPAs and scaling down of activities by corporates.
Thus, RBI can go for a smaller increase in repo rate by, say, 10 bps to signal that it remains focused on inflation and therefore dampen inflationary expectations. Banks in all likelihood would absorb the 10 bps rise in repo rate.
Historically speaking, changes have not always been made in multiples of 25 basis points. RBI had lowered the repo rate from 7.5 per cent to 7.1 per cent on March 7, 2003, and again in the same month on March 19, 2003, the repo rate was reduced by 10 bps to 7 per cent. This time, it should be a move in the opposite direction.
(The author is Chief Economist, Bank of India. The views are personal)