The major takeaway from the credit policy is that we are taking a chance on growth to bring down inflation. Friedman has triumphed over Keynes and markets know what to expect. Besides increasing rates, the policy has done much to improve the transmission mechanism to ensure that higher singular policy rates (now the repo rate), combined with measures on provisioning and higher savings account rate, translate into higher commercial lending rates which will slow growth in credit, money supply and inflation.
There are two underlying assumptions here: inflation is caused by monetary measures and can, therefore, be controlled by rate increases which will, in turn, be reflected in the base rate. Table 1 dissects the composition of inflation last year in terms of the contribution of various components to inflation in FY11 (March over March) and highlights the causes and states whether policy can bring down prices. One, it shows that monetary policy could, at best, control around 23 per cent of inflation that was caused last year. This will cover a weight of just a little above 40 per cent of the wholesale price index. Two, of the products mentioned the ones that witnessed a high increase in prices were rubber and plastic products, metals and chemicals for which the global influence was dominant. Three, a corollary is that monetary policy can seek to lower demand for these segments but cannot ensure that prices come down since global factors drive prices of metals and chemical products including plastic products. Four, the government will have to simultaneously take a stance on administered prices of oil products and minimum support price because, while non-market prices are inefficient, we cannot have the Reserve Bank of India (RBI) raising rates and inflation rising in the other 60 per cent owing to government policy. This will weaken the efficacy of monetary policy which can control only demand-pull factors.
How strong is the monetary policy transmission today? To RBI’s credit, the concept of a base rate has brought much greater transparency and made monetary policy stronger because it is based on a formula and the transmission of costs becomes a necessity rather than an option for banks. Table 2 shows the road travelled in the last year on how banks reacted to rate increases in deposit and lending rates. The base rate concept came in July and superseded the prime lending rate which remained fixed.
Table 2 reveals that rate hike transmissions have been more effective in the second half of the year than the first. This was more a result of the shortage of funds for banks during the busy season. Therefore, the transmission system will work when banks require more funds and pay higher deposit rates. Alternatively, these rates should also affect their overall cost of operations through, say, the repo borrowings. What does this mean? The RBI may also have to look at certain quantitative measures to control the amount of resources available for lending. They may include either increasing the cash reserve ratio or placing a limit on the repo window to ensure the overall cost of borrowing goes up.
Assuming that rate hikes lower growth, will that temper inflation? A regression analysis for the last five years shows that around 34 per cent of inflation can be explained by growth in credit. However, the standard Granger causality test shows there is no causal link between growth, credit and inflation.
The three arguments examined here indicate that the impact of policy changes on inflation is equivocal and the present move is not quite the conjurer’s wand, 50 basis points notwithstanding.
The writer is chief economist, CARE Ratings.
Views expressed are personal