A question of RBI's credibility

THE COMPASS

The Reserve Bank of India's intention in raising the repo rate by 25 basis points is to dampen inflationary expectations.

Briefly stated, the belief is that long-term yields have run away, thanks to the inflationary premium embedded in them, and inflationary expectations need to be curtailed.

So while short-term rates have been raised via the repo rate hike, the Bank Rate, which is supposed to signal medium and long-term interest rates, has been left unchanged.

The key question, of course, is whether the RBI will succeed in dampening inflationary expectations. Will the market believe that inflation will come down?

The answer to that question lies, as the Review of Monetary Policy points out, on four commodities "" iron ore, iron and steel, mineral oils and coal. Excluding these items the WPI inflation rate is only 40 basis points higher than last year's 3.8 per cent.

The crucial fact is that the prices of all these items are globally determined, and clamping down on domestic demand will have little impact on their prices.

In other words, nothing the RBI can do will impact their prices, although lower taxes, and other policy measures like forcing oil companies to bear the rise in fuel costs do help in containing domestic inflation.

To be sure, high oil prices may very well trigger a global slowdown, or the Chinese authorities may cool commodity prices by slashing growth, in which case inflationary pressures too will recede, but that has nothing to do with the RBI's monetary policy.

Under these circumstances, the market is likely to continue to react to the inflation figures, rather than to the central bank's attempt to rein in inflationary expectations.

On the other hand, it's also true that the 25 basis point rise in the repo rate is unlikely to cause any damage to the growth momentum built up in the economy.

As the review points out, investment demand is strong""""even if interest rates across the board are to rise by 25 basis points, it will make little difference to investment plans. If the demand exists, a few percentage points rise in interest rates will not make a difference""-corporates borrowed money at 17 per cent during the nineties to set up new units.

The bigger impact may probably come from the hike in risk weights on housing and consumer credit. This means that banks will have to set aside larger amounts of capital for these loans, with the result that the return on capital will fall.

Consequently, it's very likely that housing and other consumer credit will have to be re-priced, which could lead to lower growth in these sectors.

So why then did the RBI raise its repo rate? Perhaps because the markets had started rising long before the RBI took any action, and any delay in raising interest rates could have reflected on the central bank's credibility.

After all, if the Mexican central bank can raise interest rates for the seventh time this year with inflation at 5.1 per cent (and Mexico is an oil producer), surely the RBI can raise the repo rate by 25 basis points?