Interest-ing differences

The revealing graph published in yesterday's Smart Investor section of this newspaper provides food for thought about the apparent linkages between US and Indian monetary policy. In October 2004, the Reserve Bank raised the reverse repo rate for the first time in many quarters, from 4.5 per cent to 4.75 per cent. At that time, the Federal Reserve's Fed funds rate in the US was 1.75 per cent. Both rates have increased steadily since then, but the gap between them is down to half a percentage point (or 50 basis points). The reverse repo rate today stands at 5.75 per cent while the Fed funds rate was raised to 5.25 per cent last week. It might be argued that this gap is not enough, given the different inflation rates in the two countries. For that reason, if nothing else, one should expect a rate hike when the RBI makes its next policy announcement later this month.

One question that arises is whether the RBI has taken to coat-tailing the Fed on interest rate increases. In fact, going back before October 2004, the Fed began hiking its rate around July of that year, after many months of stability at 1 per cent. If this is indeed a correct interpretation, all one has to do to predict the RBI's quarterly announcement is to look at what the Fed did just before. However, there is another dimension to the movements between the benchmark rates in the two countries. Fed watchers in the US tend to look at its actions in terms of a mark they refer to as the "neutral" rate. This is what the Fed funds rate should be when inflation is stable while growth is not threatened. The Fed's ability to respond to any shock was believed to be at its strongest at this neutral rate. While the level of the neutral rate is somewhat subjective, most people believed that, in the macroeconomic circumstances of a year or two ago, it lay in the range of 3.75-4.25 per cent. As long as the actual rate was below this range, the Fed's continuous increases were perceived as simply an attempt to achieve the neutral rate as quickly as possible. However, when the rate went above this range earlier this year, perceptions changed. The monetary policy stance had now shifted from neutral to actively anti-inflationary.

The notion of a neutral rate has not yet taken root amongst RBI watchers. As a result, every interest rate increase is interpreted as a hardening of its anti-inflationary stance, if not a knee-jerk reaction to what the Fed just did. This is unfair to an institution that is diligently building up its reputation as an independent central bank, sensitive to both domestic and global considerations but captive to neither of them. From this perspective, the RBI's interest rate policy can be viewed as an appropriate response to domestic inflationary conditions as well as to the pressures on the capital account if interest rates diverge too much. Indeed, the Fed moved interest rates more quickly on the way down, and has done the same on the way back up, whereas the RBI has worked with stickier rates in both directions.

Going forward, it might help to strengthen the communication between the RBI and the markets, something which many observers believe is inadequate if a neutral rate were to emerge in India as well. Then, the RBI's actions can be judged in relation to its own benchmarks rather than somebody else's.