Signalling the risks

RBI Governor YV Reddy's decision to hike the reverse repo rate by 25 basis points may have surprised the bond market, but it's pretty clear from the monetary policy statement that the central bank is concerned about the potential for higher inflation, and wants to nip inflationary expectations in the bud.

Prior to the policy, most market participants believed that with headine inflation headed downwards, thanks to the base effect, and with debt market rates already inching up, the RBI could have postponed an increase in interest rates.

Instead, it has chosen to bite the bullet, preferring a pre-emptive strike against inflationary expectations.

The governor has clearly stated his concerns about inflation in the policy statement.

It has been argued sometimes that much of the price rise in India is on account of "imported" inflation, and monetary policy is powerless to deal with it.

However, the RBI's argument is that, "the rise in oil prices appears to have a large permanent component." and the full pass-through of international prices to the domestic level has not occurred.

The central bank also says that the experience of the oil price shocks of the 1970s and 80s is that "in the face of a significant supply shock, it is not prudent for monetary policy to be overly accommodative".

Other factors that could give rise to inflationary presures on the demand side are high capacity utilisation levels in some industries, the second-highest growth in 55 years in non-food credit, and higher government borrowing.

Higher US interest rates are another concern. Taking all these factors into consideration, the central bank has pointed out that, "Going forward, the risk that inflation may turn out to be higher and growth lower than currently anticipated has increased."

In short, although the RBI has forecast the inflation rate on a point-to-point basis at 5.0 to 5.5 per cent, it is worried that inflation may overshoot that mark.

At the same time, the Reserve Bank wants to ensure that growth is not harmed, which is why the hike has been limited to only 25 basis points, and there has been no action on increasing the cash reserve ratio, in spite of the liquidity in the money market.

Also, the RBI has not changed the repo rate, and the signal that it will continue to lend at 6 per cent will be a source of comfort to banks. It has also said that it will stand ready to provide liquidity if needed through open market operations.

Apart from the inflation and interest rates, the RBI has also flagged some other issues of concern. One of them is the fact that since the RBI will not be participating in primary issues of government securities post-FRBM, primary dealers will need to be strengthened to ensure that the government borrowing programme goes through smoothly.

Hence the need to expand the business of primary dealers""merging them with banks could be one option. Overall, while the stance of monetary policy remains the same as in the October policy statement, the clearest indication of the changed environment is provided by the RBI's admission that the interest rate cycle has definitely turned.