The next policy review of the Reserve Bank of India is due on September 16. As usual, the market has started speculating about the RBI's move on interest rates.

Some sections of industry hold the view that the RBI should remain ahead of the curve by going for a pause in rate hikes — following deceleration in growth in Q1 of 2011-12 and fears a global slowdown. The case for a rate pause is based on arguments that a further hike would lower growth numbers for the rest of 2011-12.

Those who cite the global slowdown to argue for a pause in rate hike seem to overlook the fact that growth concerns of the developed world and India are different.

The immediate and main economic challenge in the developed world is to avoid another painful recession. For countries such as India, the challenge is to bring down inflation.

Macro numbers

All through, the RBI has maintained that it does not mind sacrificing a bit of growth for bringing inflation down to more tolerable levels. The real question is whether we have sacrificed growth significantly as to worry about growth taking another major dip if the developed world enters into a recessionary phase. Let's look at some macro numbers.

The GDP growth in Q1 of 2011-12 has been similar to that in Q4 of 2010-11. The trade data indicate that external demand remains robust, with domestic activity being resilient.

Exports have grown by 54 per cent in the first five months of this fiscal compared with 37.5 per cent in fiscal 2010-11.

Import growing at more than 40 per cent in the April-August period is also suggestive of brisk economic activity. Just to give a comparative perspective, imports in the 2010-11 had grown by 22 per cent.

Credit growth in the system has grown 2.7 per cent so far in 2011-12. The comparable figure of last year was 2.8 per cent.

However, the credit disbursed by banks till this time of 2010-11 involved a significant chunk for the telecom companies for purchase of 3G spectrum. If that is netted out, credit growth in 2011-12 has not been as slow as it is made out.

Within the vehicle space, demand for four wheelers has turned negative but that in the commercial vehicles segment has shown reasonable growth. The IIP data also do not suggest a broad-based growth slowdown. The general IIP index grew by close to 6 per cent during April-July.

This is the time to take a call on whether to continue with the rate hike or go for a pause. Persistence of inflation at high levels in spite of 11 rate hikes since March 2010 leads many to think that monetary policy has been ineffective.

The efficacy of policy can be better appreciated by posing a counter question — what would have been the inflation levels had the RBI not increased policy rates?

I am sure all the ardent supporters of a rate pause would agree that inflation would have been much higher around this point of time had the series of rate hikes not been undertaken.

Deeply entrenched

The case for a rate pause is also based on the argument that inflation will ease given the high base-effect. The base-effect argument may hold good in normal times, but it does not cut much ice when inflationary expectations are deeply entrenched in the system.

For instance, during March-July 2010, inflation was more than 10 per cent. Had the base-effect been really working, the inflation numbers between March and July 2011 would have been significantly lower.

What we find instead is inflation levels close to 10 per cent during each month of April-July 2011.

That the inflationary expectations have become deeply entrenched in the system can be seen in the yield movements in G-Secs since the last policy announcement.

Compared with the time of last policy announcement on July 26, 2011, the bond markets are suggesting higher inflationary expectations in the short term.

While the yields on five and ten year G-Secs have remained around the same , the yield on one year G-Secs have increased by 18 basis points as on September 8.

Thus, there is a need for determined action on the rate front to dampen inflationary expectation.

Room for manoeuvre

If we recall, when the global financial crisis struck, there was space both on the monetary and the fiscal front for manoeuvrability.

If there is a global recession now, there is little room for policy activism on the fiscal front.

In these circumstances, the argument for another rate hike becomes stronger as it would create larger room for the RBI to ease policy if the global economy were to go for a toss again. By opting for another dose of rate hike, the RBI can signal to the market in definite terms that it means business.

In a globalised world, the economic fortunes of different countries are inter-linked. Emerging economies may have the potential to become the powerhouse of future global growth.

However, the developed economies have to play a crucial role in providing the necessary stability to the global economy by avoiding another recession.

As such, the developments in major economies will have a bearing on the course of policy pursued in India.

The US President, Mr Barack Obama, recently unveiled a $447-billion job plan and the Federal Reserve will also be deliberating its course of action to stimulate the economy during September 20-21. The Europe situation also remains in a flux.

It would serve the economy well if the RBI stays focused on controlling inflation. As such, the policy tilt should be in favour of a 25-bps hike in the repo rate.

(The editor is Chief Economist, Bank of India. Views are personal.)

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