Should the RBI be hiking interest rates?

DEBATE

Apart from the slowing down of growth in the US, the key issue is whether the RBI believes India's moved to a new sustainable growth path.

A PRASANNA,
Vice President, Fixed Income Research, ICICI Securities

"Containing inflation expectations in an environment of above-trend GDP and a credit boom is a big reason for a hike"

In June, the bond market had a spot of doubt and wobbled. To give due credit, the RBI acted with composure and courage, and brought the situation under control with a timely hike in the July review. The RBI governor needs to add foresight when weighing his decision in the upcoming review, even as the cacophony in favour of a pause is gaining strength. The key argument voiced for pausing is an uncertain US outlook and the possibility that the US policy rate may have peaked. Going by emergent signs that the housing market may stabilise in the first half of 2007, I believe that the FOMC may pull off a soft landing and may yet have to hike in 2007 to address inflation pressures.

Another argument is that past hikes and prudential measures have helped moderate incremental credit growth. If prudential measures alone were sufficient then overnight rate will still be at 4.5 per cent and the RBI would have managed to rein in credit growth by tweaking risk weights. Alas, monetary policy is not so simple. Even with a 75 basis points hike in 2006 and assorted measures, credit growth has just stabilised in aggregate terms. More work needs to be done to slow down to a 20 per cent rate.

The no-hike proponents would also have us believe that letting liquidity conditions remain tight is an alternative to hiking rates. However, stealth tightening limits the RBI's flexibility and runs the risk of diluting the essence of monetary stance since economic agents are likely to assume that liquidity tightness is a temporary phenomenon. By far, the most important reason for hiking is to contain inflation expectations in an environment of above-trend GDP growth and credit boom. No doubt, oil prices are trending down, but manufacturing prices are rising and headline inflation is poised to breach 6 per cent in the fourth quarter.

Inflation expectations are set to worsen on the back of elevated food prices and survey indications of high consumer confidence and double-digit salary growth. The central bank should also worry about reported inflation, understating actual inflation. Inflation is at least 50 basis points higher than the reported number after accounting for lags in updation. By achieving its inflation target of 5-5.5 per cent, the RBI is actually condoning 5.5-6 per cent inflation.

From a risk management perspective also, a hike makes sense. Suppose having paused, should the RBI find that inflation outlook has worsened or that the US outlook has improved, it will be left with no option but to hike in January. Better to hike now and take stock in January. Hiking rates will prove that the RBI is thinking ahead of the markets as all central banks ought to do at some stage.

Views are personal and do not reflect those of the author's organisation

INDRANIL PAN,
Chief Economist, Kotak Mahindra Bank

"Given the structural shift in the economy, the RBI could be comfortable with a higher money supply target for the year "

The pause in the US interest-hike cycle did give the feeling the RBI would pause in the monetary tightening but the recent hike in headline WPI has altered this perception and the market is how divided in its expectations.

The RBI has increased the reverse repo rate by 150 basis points (bps) from its low of 4.5 per cent in August 2004, of which three of the increases (75 bps) have come in this calendar year. These rate increases haven't yet had an impact since credit continues to grow at around 30 per cent year-on-year, money supply growth is strong at 18.5 per cent and is significantly higher than the 15.5 per cent targeted by the RBI at the start of the year. All this points to more tightening.

There is, however, a structural shift that's taking place. Easy global liquidity (the feel-good factor emanating from a robust stock market) and strong external demand (an export growth in excess of 20 per cent) have fueled strong manufacturing growth in India. The RBI is likely to overshoot its money supply target of 15.5 per cent for the year. But that was based on an assumption of a real GDP growth of 7-7.5 per cent and an inflation of 5-5.5 per cent. The first quarter GDP growth has been much stronger at 8.9 per cent and the RBI could be more comfortable with a higher money supply target for the rest of the year, especially as there is no significant evidence of the high money supply growth fuelling inflation. Lingering concerns such as on housing credit can be addressed by sector-specific measures.

Given that global oil prices are now on the wane, the RBI's concern over a build up of inflationary pressures must also have eased. The recent increases in the primary articles prices is seasonal, so while the RBI can continue to stay hawkish on inflation, the risk of an actual policy tightening has eased considerably.

The RBI governor had spoken of the importance of global factors "" global central banks are likely to be dovish on interest rates given the slowdown in US housing that was central in fuelling the consumption boom. The impending US slowdown will have an impact on the Euro region.

In my opinion, recent developments allow the RBI to breathe easy and afford a wait-and-watch mode for monetary policy direction. RBI Deputy Governor Rakesh Mohan had indicated some time back that "monetary policy actions in terms of effect have fairly long lags". This could ultimately emerge as the guiding factor and allow the RBI to maintain a status-quo on policy rates on October 31.

Views are personal and do not reflect those of the author's organisation