A case for tightening

Now that inflation has hit a two-year high of 7.51 per cent, and with real returns on bank deposits deep in the negative territory, it's time the Reserve Bank of India took a long hard look at its easy money policy. Liquidity is still abundant in the money market, as seen from the State Bank of India's recent decision to lower rates on short-term deposits at a time when the inflation rate has shot up.

It's time, therefore, for the RBI to start draining some of that liquidity. There are several arguments that are often used against the central bank raising interest rates. One of them points out that much of the rise in inflation is due solely to cost-push factors, factors over which the RBI has little control.

This applies not only to crude prices but also to raw material and commodity prices, which are set by global supply and demand. Tightening monetary policy may not have much effect on these prices, as reducing domestic demand may not do much to reduce global demand.

The second argument is that the industrial recovery in the country is still at a nascent stage, and could be nipped in the bud if interest rates are raised. This argument is easily disposed of""the rate that matters, as Dr Rangarajan has recently pointed out, is the real interest rate""so long as real interest rates are reasonably low, companies will not find it a disincentive to borrow and invest, even if nominal interest rates rise.

In any case, with bank credit growing at a year-on-year rate of 21 per cent, the industrial recovery appears to be very robust. And while it is true that cost-push factors do have a lot to do with the current rate of inflation, it is also true that many industries are operating at or near full capacity, as a result of which they are in a position to raise prices.

The lack of spare capacity makes it increasingly probable that demand-pull factors too will come into play soon, and the RBI must take a pro-active stand in the matter, keeping in mind the lagged effect of monetary policy.

There is also little doubt that monetary policy throughout the world, after pumping in unprecedented amounts of liquidity in the last few years, has now started tightening. Inflation rates are moving up across the world, going up to a multi-year high of 5 per cent in China and to 3.2 per cent in the US.

Central banks have responded by raising interest rates, or, in the Chinese case, by clamping down on credit. A comparison of US and Indian inflation and interest rates on government bonds shows that the yield on the US 10-year treasury note is about 150 basis points higher than the inflation rate, while back home the yield on the 10-year government security is still well below the inflation rate.

Clearly, therefore, the RBI seems to be well behind the curve when it comes to tightening. Now that India is integrated into the global economy, the RBI cannot afford to be immune to international pressures to raise interest rates, pressures that are bound to grow if the US Federal Reserve raises interest rates yet again on Tuesday.