Excessive caution

In raising the reverse repo rate (the rate which it pays to banks to park their excess funds with it) by 25 basis points in a second successive announcement, the Reserve Bank of India (RBI) has surprised most observers. Having done exactly this just three months ago, the RBI was generally expected to wait and watch developments on both the domestic and global fronts before committing to the rather determined anti-inflationary posture it eventually demonstrated yesterday. Of course, it provided explicit rationales for its actions, premised on a macro-economic scenario noticeably different and more challenging than it had visualised last quarter. From the perspective of this scenario, the rate hike was clearly the logical thing to do.

On the domestic front, the main change in its outlook is that GDP growth during the current year is now projected to be higher than October's estimate of 7-7.5 per cent. Given that advance estimates for the first half (April- September) put growth at fractionally over 8 per cent, the RBI has raised its band for the full year to 7.5-8 per cent, which then leads to concerns about over-heating and the inevitable inflationary pressures. Growth in credit has also accelerated in recent months, consistent with the assessment of (excessively?) buoyant demand. It is odd to be concerned about inflation when wholesale prices are increasing by barely 4 per cent, but the RBI may be calculating that the full impact of higher oil prices has not been passed on to the economy. From this flows the fear of inflation accelerating over the next few months. On the external front, the RBI believes that the world as a whole is growing somewhat more strongly than earlier estimates, which, in combination with the high oil prices, increases the risk of accelerating inflation. Although it sees the US Federal Reserve as being close to, if not at, the end of its long series of rate increases, it perceives the trend across emerging markets as being one of either tightening or, at least, withdrawal of an accommodative position.

With some bias towards anticipating negative outcomes, this is a plausible assessment of the domestic and global factors that should influence a country's monetary position. But, within this overall picture, there are hints of spontaneous moderation in economic growth. The latest industrial production numbers, for November 2005, showed a deceleration in manufacturing output when compared to the previous months. Third-quarter corporate profits do not appear as buoyant as the previous two quarters of this year. Headline inflation remains quite modest, around 4.2 per cent, according to the latest numbers. Even allowing for the full pass-through of oil prices, the increase is hardly likely to be catastrophic. Speaking of oil prices, while there has been a recent spurt, the sustainability of levels much beyond $55 a barrel is not yet established. All these factors suggest that the prudent move to sustain a relatively high-growth, low-inflation scenario would have been to hold steady. In raising the benchmark rate rather than waiting for more unambiguous evidence of either overheating or cooling down, the RBI may have overplayed its hand and, in fact, tilted the scale of probabilities towards the former. In a situation of tight liquidity, a further push to interest rates does threaten major contributors to growth, which are relatively sensitive to those rates.