The Reserve Bank of India’s (RBI’s) decision, in its first ever mid-quarter monetary policy review, to hike the repo and reverse repo rates was along expected lines, even though the new inflation numbers made some salivate that the central bank may hold back on rate hikes. Some would argue that the half-a-percentage increase in the reverse repo rate was somewhat higher than expected but the increase appears to be driven by purely technical factors (narrowing the corridor between the two short-term rates) rather than the need to send an aggressive policy signal. In a world fraught with uncertainty, this predictability is welcome and the RBI’s consistent approach to interest rates policy needs to be applauded. The rationale for the rate hike was clear. The economic recovery seems to be consolidating as most macroeconomic data suggest. Thus, RBI does not need to fret as much about higher interest rates hurting growth as it did in the past. On the other hand, inflation still remains uncomfortably high and that gets top priority in monetary management. The central bank elaborates on this a little. High inflation is translating into negative real interest rates that, in turn, is hurting deposit growth. That could potentially impinge on credit growth going forward if banks find themselves starved of funds. The objective of the interest rate hike would nudge banks into hiking deposit rates and bring the system back to a more sustainable equilibrium.
How much more will policy rates go up? RBI points out that there were two facets to monetary policy over the past year. One was the need to bring monetary policy back to “normal” from the ultra-expansionary mode of the post-financial-crisis period. The second facet was the need to respond to macroeconomic developments, specifically on the fronts of growth and inflation. The review points out that the process of “normalisation” is almost complete. Thus the remit of monetary policy would now be to respond solely to emerging and expected macroeconomic conditions. While the policy emphasises that the absolute level of inflation is uncomfortable, it also concedes that the acceleration in inflation has stopped and the first signs of a downturn in non-food manufacturing inflation are visible. It attributes some of this moderation to the policy actions it took in the past. The implication is that if headline inflation does abate by the end of the year as most economists predict, RBI is likely to come to the end of its rate cycle. There are some risks though. While the central bank seems comfortable with developments in the global economy, it points to the risk of global stability leading to higher commodity prices and hence higher inflation. This is a step back from the optimism it exuded a few weeks ago about global commodity prices softening on account of global demand factors, especially China’s expected slowdown. Better news on the world economy, and from China, might put capital flows back on track but might just force RBI to intensify its inflation vigil.
Finally, RBI is known for its candour when it comes to discussing the dire state of the country’s fiscal balances. However, for once, it seems reasonably sanguine that the near-term fiscal situation is somewhat comfortable. “Higher than expected realisations on 3G and broadband wireless access (BWA) auctions combined with buoyant tax revenues,” it points out, “have virtually eliminated the risk of the fiscal deficit overshooting the targeted 5.5 per cent.” If inflation risks dissipate going forward and the fisc stays in check, interest rates and bond yields might not move much higher from current levels. If inflation, however, refuses to be tamed, RBI is unlikely to take its hands off the monetary lever.
