Should RBI raise interest rates?

A rate hike will set back the recovery process, but if RBI does raise rates, it will be to prevent the rise in food prices from spilling over to other sectors and to dampen inflationary expectations.

Dharmakirti Joshi; Director and Principal Economist, Crisil Ltd

In its October policy, the Reserve Bank of India had set the tone for monetary tightening. The exit from an accommodative monetary stance was signalled via reversing some of the unconventional liquidity-boosting measures announced earlier.

Raising the SLR was one of them. RBI nevertheless refrained from explicit tightening via interest rate hikes as the recovery was considered fragile.

What has changed since then? Compared to October 2009, the economy now appears to be on stronger legs. The second quarter GDP growth of 7.9 per cent positively surprised market participants and policy-makers alike. Until the first quarter of this year, government spending was the key driver of demand in the economy. It still is, but now private consumption demand too is supporting it.

Real private final consumption expenditure grew at 5.6 per cent in the second quarter versus 1.6 per cent in the first quarter. The investment demand too has picked up.

Recent data shows that exports have started growing, albeit over a depressed base. All this has improved the growth prospects for the current fiscal, leading all the key forecasters to scale up their India growth estimates for 2009-10.

While the economic scenario has improved significantly since October 2009, some concerns on the growth front still remain, given the uncertain global scenario.

Another development since the last policy is the pick-up in inflationary pressures. In its October policy, RBI had raised the fiscal yearend inflation target to 6.5 per cent. Given the speed with which inflation is rising, it is quite likely that this target will be breached much before that. The weak base of last year is further pushing inflation up.

Under normal circumstances, a simultaneous rise in growth and inflation would have triggered a rate hike. The nature of inflation, however, makes the monetary policy decision quite complicated.

The pressure on inflation is largely due to a supply shock from agriculture and not due to demand factors. For the month of November 2009, food inflation stood at 17 percent, fuel inflation was negative and manufactured product inflation was 4.0 per cent.

The weekly data on food and fuel as on December 19 shows inflation is firming up in these categories from November levels. It is well understood that the spike in food prices cannot be arrested by raising interest rates.

The pressure from supply side shock to food prices has, however, been persistent and is reflected in the double-digit inflation in the Consumer Price Index (CPI) since October 2008.

 This can spill over to general inflation if the demand is picking up and monetary conditions are easy. Raw material/commodity prices have also posted a significant rally recently. This has the potential to further pressurise inflation by raising the cost of production.

The nature of growth and inflation in India at the current juncture does pose a dilemma for RBI. When the downside risks to the economy had increased with the onset of recession in advanced economies, it was easier to decide on a swift rate reduction.

With recovery gaining pace and inflation in the uncomfortable zone, there is little doubt that we will soon see an interest rate hike. But timing the rate hike in today's scenario is a major challenge not only for the Indian central bank but also for many others around the globe. If you raise rates too soon, you risk jeopardising the recovery that has just begun, and if you do it too late, you risk inflation.

The monetary policy has to be vigilant as it impacts the economy with a delay. Since the last policy announcement in October, the recovery is stronger and inflationary pressures are higher. I expect RBI to now move from implicit tightening to explicit tightening to address the potential second-round effects of food price increases on general inflation and also to tame inflationary expectations which are now rife.

The danger in waiting for the recovery to firmly take hold is that it could be too late to tame inflation. RBI could begin with CRR hike and a 25 basis points increase in short-term interest rates in its January policy. Following that, interest rate increases could be calibrated, depending on the strength of the recovery and inflationary pressures.

Chandrajit Banerjee; Director General, CII

As India, and indeed the rest of the world, shows signs of recovering from the global economic crisis, the task of central bankers is becoming more complex.

While the fiscal and monetary support has helped economic recovery, the recovery itself is not yet strong enough to warrant an increase in interest rates.

Further, with the hardening of food prices, the RBI governor will face many calls to tighten policy at the third quarter review of Monetary Policy at the end of this month.

Yet it is worth examining the merits of an immediate tightening versus a wait-and-watch approach. While the recent numbers on industrial growth have been impressive, it is uncertain whether they can be sustained in the event of a withdrawal of monetary stimulus.

The sectors which have been doing well are consumer-driven and, therefore, are sensitive to interest rates. Indicators of investment demand, such as capital goods production, still remain subdued.

An increase in interest rates would serve to slow down consumer demand which could have a further negative impact on firms' investment plans. In any case, there is a risk that the weak monsoon will have a negative impact on rural incomes and hence on consumer demand.

It is, therefore, quite likely that the recent pick-up  in growth needs to be nurtured by a soft interest rate regime.

The main driver of both CPI and WPI inflation has been food prices, which have been increasing at a rapid rate. The price of food articles has increased by as much as 19-20 per cent during December, with the main contributors being cereals, pulses, fruit and vegetables, meat and fish. The main reasons for the sharp rise in food prices are the shortfall in food production and weakness in distribution.

The deficiency in this year's monsoon has led to a sharp 18 per cent drop in the kharif food grain output. This could have been offset through wider disbursement of government stocks. However, the government response in terms of distribution has been poor, as indicated by food stocks remaining far higher than what is required as per the buffer norms.

It is clear that food prices are being driven up by certain structural and policy-induced factors. The effectiveness of monetary policy in dealing with this is questionable. Monetary tightening will be a blunt instrument, curbing demand across sectors when the problem clearly lies in a single sector.

Another concern is that interest rates are already high in India due to the impact of a sudden increase in government borrowing following the onset of the global financial crisis. The benchmark yield on 10-year government securities has hardened from a low of below 5.0 per cent in January 2009 to about 7.6 per cent currently. This has, to some extent, off-set the impact of monetary easing, so actual lending rates have not declined to the same extent as policy rates.

Bank credit disbursals have just started picking up from a 12-year low, though the banking system still has surplus liquidity as indicated by the amount of funds being parked with RBI in its daily reverse repo auctions.

Recent data for the week ending December 18 shows that while the year-on-year increase in banks' credit is just 11.3 per cent, banks' investment in government bonds has increased by 24.2 per cent. An increase in RBI's policy rate at this stage would only encourage banks to stay away from commercial lending, rewarding them for their risk-averse behaviour.

Monetary tightening would only result in a further increase in bond yields which would increase the government's interest costs and pose a challenge to fiscal consolidation.

Instead, it would be important for the government to stick to its borrowing targets for this year and try to reduce its borrowing in the coming year. Once private sector demand picks up, it will be difficult to sustain the government's current level of borrowing. Raising interest rates without first reducing government borrowing will only lead to the private sector being 'crowded out'.

Image: RBI Governor D Subbarao. Photograph: Reuters