Should the RBI hike interest rates?

DEBATE

What's critical is whether the RBI feels the current inflation levels are driven by primary articles where supply-side issues appear more important.

MOHAN SHENOI,
Group Treasury Head,
Kotak Mahindra Bank

"RBI's concerns on overheating remain. The central bank will likely hike the reverse repo rate by 25 bps and leave the repo rate unchanged".

It is uncertain times once again as market participants try to predict the RBI's next move at its monetary policy review on January 31. In its current cycle of the tightening of monetary policy, RBI has increased the reverse repo rate by 150 bps from its low of 4.5 per cent in August 2004, of which three of the increases (totalling 75 bps) have come in 2006. In October 2006, RBI preferred to increase the repo rate by 25 bps to 7.25 per cent and skipped hiking the reverse repo rate. Further, in a recent move, RBI increased the CRR by 50 bps effective in two phases to contain credit growth.

The monetary tightening, however, has not impacted growth. GDP growth in the first half of 2006-07 was 9 per cent and industrial production growth averaged 10.6 per cent in April to November 2006. Credit growth continues to remain robust at around 30 per cent and money supply is growing at 19.4 per cent. Aggregate demand conditions are strong with growth in the consumer goods segment at around 10 per cent. Investment demand is robust with capital goods production averaging 16 per cent in April-November 2006. High capital goods production is being supplemented by strong capital goods imports.

Given this, RBI's concerns regarding overheating still remain. Further, inflation concerns have surfaced again. The headline WPI inflation for December 30 is at 5.58 per cent, higher than the comfort zone of RBI. And given the strong upward revisions in the previous data that have been witnessed in the past few weeks, the actual headline WPI inflation could well be closer to 6 per cent. There is a continuing price pressure from the primary and manufacturing articles, with manufacturing articles rising to around 5.04 per cent. The recent dip in the global crude oil prices and the downward revisions in the domestic prices of petrol and diesel have limited the pressures on headline WPI inflation for the moment. Though international oil prices have now dipped to around $50 a barrel, OPEC is likely to keep the pressure up to push it back, thus not providing a sustained comfort for headline WPI inflation. The other factor that has limited the rise in the headline WPI inflation despite demand pressures is the appreciation of the rupee, resulting in cheaper imports.

Till recently there were expectations of a pause in the interest rate hardening cycle in India thanks to the belief that global monetary policy tightening has ended and can also start easing off in 2007. However, this now appears unlikely. The Bank of England unexpectedly tightened its signaling rate to 5.25 per cent on January 11, 2007 while ECB's Trichet maintains a hawkish stance and is likely to tighten the policy in March 2007. In the US, any thoughts of an early easing of the monetary policy are being dispensed with after some strong data was reported. Most significant amongst these were the employment numbers that indicated a continuing tightness of the labour markets in US, and raise the possibility of a wage-price spiral. Even emerging market economies such as Korea stayed on a tightening cycle with its recent increase in the CRR.

The RBI is thus expected to maintain a hawkish bias at its January 31 monetary policy review and there appears to be a significant chance of raising the policy interest rates at only the lower end of the interest rate corridor. The possible factor that could deter increasing policy rates at the upper end of the interest rate corridor is the already high short-term rates that have led to a sharp increase in the banks' borrowing costs. The tightening stance of the RBI is likely to depend on its own expectations on liquidity. My sense is that rupee liquidity can ease in February and March with higher government spending and larger absorption of foreign currency by RBI. The increase in reverse repo rate is unlikely to lead to a sharp slowdown in production as was witnessed during 1994. Unlike in the previous boom phase of early 1990s (associated with excessive exuberance over the reforms process), Indian manufacturers today have been more cautious in building up their production capacities and managing expectations.

ABHEEK BARUA,
Chief Economist,
ABN Amro Bank

"Another round of interest rate hikes could mean that the economy will 'crash-land', rather than glide smoothly down a lower growth plane"

My view is that the RBI shouldn't hike rates. It has taken a fairly drastic step by hiking the CRR last month. This seems to have had the desired effect of pushing up interest rates across the spectrum, particularly in segments like retail loans that had perhaps "overheated" a bit. There is some evidence that loan growth in these segments had begun to moderate even before the CRR was increased. With the fresh round of lending rate revision, growth rates could soften a bit more. I would think it's sensible to wait a while and get a better fix on where the credit cycle is headed before ramping up rates again.

Do current headline inflation rates warrant a rate hike? Analysis shows that a big contributor to rising inflation has been high primary or farm product prices, and the way to harness these price pressures is to ease supply rather than curb demand through monetary measures. Besides, most of the price pressures are confined to just a few commodities like oilseeds. This should make the task of supply management easier. That said, primary product inflation has been a little more persistent than usual. One could argue that this was due to growing inflationary expectations that had to be curbed through interest rate and monetary signals. My assessment is that the hike in the repo rate in October and the CRR increase have been adequate for this. As far as manufactured product inflation goes, a part of the rise is actually related to the primary product cycle. "Food product" inflation has thus been a big contributor. There are some signs of a rise in pricing power in other categories but they are certainly not alarming. There are two things that the RBI needs to be careful about in its monetary management strategy. First, there are a number of risks looming on the domestic and international fronts that could take a toll on domestic economic growth. Given these, another round of interest rate increases could just mean that the economy will "crash-land", rather than glide smoothly down a slightly lower growth plane. Second, rising domestic interest rates tend to support the domestic currency. This link between interest rates and currency seems to work even when capital controls block the more obvious arbitrage possibilities. A rising currency hurts export demand, squeezes export profitability and could dent the central bank's balance sheet if there is a large stock of foreign exchange reserves on its books. Thus, further appreciation of the rupee might not be desirable at this stage.

Will the RBI hike the signal rates in the policy? My apprehension is that it will, since it seems keen on projecting itself as a tough inflation fighter. Going by the statements coming from the central bank in the past, this inflation-tolerance level is widely construed to be 5 per cent. I am afraid that most of the January inflation numbers are likely to be close to 6 per cent and this might just push RBI Governor Y V Reddy to push rates up. In terms of the specific rate or rates that he chooses to hike, he is spoilt for choice. He could choose to raise just the reverse repo rate and leave all other rates unchanged. This is likely to be a little lame, given that a similar tack in October left the markets a little cold. He could hike both reverse repo and repo rates and that would mean short term funds will become even dearer. Finally, there is the option of pushing up the bank rate that has no direct impact on things like refinance but is a strong signal that the central bank prefers a higher interest rate regime. At this stage, it would be logical to hike the bank rate, instead of tinkering with the shorter term rates. My prediction, however, is that Dr Reddy will leave the bank rate untouched and continue his focus on the repo corridor.

There are some complications arising from the possibility of a reduction in the SLR. If it does pare the SLR, long bond yields will go up immediately but banks will be left with more free funds or liquidity. Given its concerns on inflation, it is unlikely that the RBI will sit on the sidelines. If it indeed cuts the SLR (my sense that the initial cut will not be more than half a percentage point), it might want to offset the liquidity impact by hiking the cost of liquidity. This could be another motive for hiking rates.