The US Federal Reserve has raised the fed funds rate for the ninth time. More hikes are expected. In India, the RBI raised rates in April. Are interest rates in India set to go up further? Will the fact that inflation is now low, keep interest rates unchanged? Rising oil prices, domestic demand conditions and the current account deficit suggest that there is a case for RBI to raise rates. The monetary policy review on July 26 could see the RBI announce a hike in interest rates. The hike may, like the fed fund rate increase of 25 basis points, be quite small.
In the credit policy announcement in April, RBI governor Y.V. Reddy raised the reverse repo rate, the short-term interest rate, for 2005-06. He left the bank rate, which is the medium term rate, and the cash reserve ratio of banks, which determines how much banks can lend, unchanged. In this way he tried to counter the upward pressure on inflation, without hurting the industrial growth recovery taking place. Raising the short term rate gave the indication that rates were on their way up, without immediately raising borrowing rates. It also helped suck excess liquidity out of the system. The policy seems to have worked reasonably well. Even though RBI continued to intervene in foreign exchange markets, raising liquidity in the system, inflation did not spike and growth has not faltered.
The lastest data shows that inflation has touched a 2 year low of 4.1 percent (for the week ending June 18). But can we depend on it to remain low with no further policy intervention? Global oil prices have risen far beyond expecations. If they continue to rise, domestic oil prices may have to be raised yet again. Growth in industry is healthy, the fiscal deficit is high, and the pressure on demand is likely to remain. In addition, the monsoon may not be normal.
What are the options before the RBI? It could do nothing if it is completely confident of low inflation. But given the above scenario, it may take a more cautious approach. One option would be to raise interest rates. The choice may be between raising the reverse repo rate, the bank rate, the cash reserve ratio or to use any other instrument that Dr Reddy feels is suitable, that would have the effect of raising rates. The rate increase is unlikely to be high. Perhaps something that leads to a 25 basis point increase in the short term rate. Dr. Reddy has, in the past, followed a policy of caution, and it has served him well. In this case too, Dr. Reddy may like to be cautious.
When inflation is on account of supply side factors, it is risky to raise interest rates. An oil price shock which puts pressure on the cost side of companies, combined with an interest rate shock, which puts further pressure on costs and pulls down retail consumer demand, can push industry into recession. Morevoer, as the banker to the government, the RBI is unlikely to want to place a much higher burden of interest payment on the government. An increse in interest rates will also hurt banks, most of whom have interest rate risk exposure. The hike must therefore be small.
An additional option for controlling inflation, if and when it occurs, is an appreciation of the rupee dollar rate. This will reduce the rupee price of imported products especially oil, and help to control the price rise. However, in the next few months, left to itself, there may be pressure on the rupee to depreciate. On the current account, both the oil and the non-oil import bill are likely to rise if oil prices keep rising, and the domestic economy does not slow down. On the capital account, the rise in US interest rates and the narrow differential between foreign and domestic interest rates, is unlikely to attract inflows. Without the expectations of appreciation the existing interest differential will become even more unattractive. The RBI will have the option of selling dollars to engineer an appreciation. This will also help suck out liquidity from the system. The RBI may be constrained in the use of this option by the loss of competitivenness of exports. Foreign exchange intervention to create rupee appreciation may thus, if utilised, only be a short term and limited option. It is unlikely to be used as the only tool to control inflation. It can be used in conjunction with the interest rate policy.
Ila PatnaikIla Patnaik