Taking an interest in credit

Indian Express, 2 February 2007

The RBI announced a hike in interest rates in its credit policy announcement this week. What is a credit policy, and how does it matter?

What is a credit policy?

The credit policy or monetary policy announced every quarter by the RBI is the mechanism through which the monetary policy affects prices and output in the Indian economy. The main channel through which a central bank affects monetary policy is through interest rates, the price at which it lends money to the economy. It raises interest rates when it wishes to reduce inflation, as was done in the policy announcement on the 31st.

What happens when interest rates are raised?

When interest rates go up, the cost of borrowing increases. This makes individuals and firms put off some of the expenditure that they may otherwise have undertaken. It may be that an individual was planning to take a housing loan, but a rise in interest rates makes the EMI larger than he can afford at his current salary. This will prompt him to borrow less or not to borrow. Similarly, a firm may have been planning to expand. However, at a higher interest rate, some projects become unviable. In a country of a billion people and a million firms, a small interest rate hike would only affect only a small number of borrowers, but it does slow down the economy. When borrowing has already taken place, and a floating rate contract was used, the interest outgo rises with higher rates, thus reducing the money available to spend on other things. The contraction in demand is not immediate, as it takes time for spending decisions to change and for them to have an effect on the economy. In developed countries this channel may take a year or two to have an impact. In India we do not have enough evidence to indicate how long the lag is.

What prompted RBI to raise rates this week?

The inflation rate based on the consumer price index (CPI) has been rising in recent months. From a level of 3 percent in early 2004, the inflation rate based on the CPI for industrial workers rose steadily over a period of 2 years to nearly 7 percent. Inflation as measured by the Wholesale Price Index (WPI) also accelerated from less than 3 percent two years ago to 6 percent in recent weeks. This sharp rise in inflation is one of the main factors that has led to a hike in interest rates. As Finance Minister P. Chidambaram has often said, an inflation rate of more than 4 percent is intolerable. Thus the government has to take action to bring down the inflation rate.

But is inflation not a consequence of food shortages and oil price hikes?

Since food and oil prices tend to be volatile, a term `core inflation' is used for inflation computed for non-food, non-oil commodities. The WPI consists of 3 main components. Primary articles that include food articles and commodities constitute 22 percent of the index, fuel constitutes 14 percent and manufactured goods constitute the bulk, which is 64 percent. In recent weeks food prices have been rising the fastest and inflation in oil prices has declined. With manufactured goods, inflation has been rising at a rate higher than 5.5 percent. So even if we put aside food and oil, inflation exceeds Chidambaram's 4% limit.

Who are the gainers and losers from the interest rate hike?

Borrowers will be losers in the immediate future because loans will become more expensive. In the longer run, when inflation comes down, everyone, especially the those with fixed salaries, who feel the pinch of inflation will gain from lower price rise. The most important benefit of low and stable inflation is higher private investment with a lower incidence of mistakes. When inflation is low and predictable, there is better certainty about the future in the mind of an investor. Greater certainty allows people to make better decisions about investment. The international evidence shows that when inflation is low and predictable, the fluctuations of GDP growth are reduced, which benefits everybody. The path to stability of the macroeconomy lies through devoting the entire power of monetary policy to one task: that of stabilising inflation.

Why raise rates at all? Why not just tolerate inflation and enjoy higher GDP growth?

In the short run, it is always possible to squeeze out a little extra growth from the economy by jolting it with higher inflation. The acceleration of the CPI from 3% to 7% has certainly had something to do with the remarkable GDP growth that has taken place in 2005 and 2006. However, 7% inflation is harmful, and the effect on GDP growth is short lived. We get higher GDP growth when inflation rises from 3% to 7%, but not if inflation stays at 7%. If another bout of accentuated GDP growth is desired, another jolt of inflation acceleration will be required, going from 7% to 11%. This style of thinking - of obtaining brief increases in GDP growth by having acceleration in inflation - fundamentally destabilises the economy. High inflation is harmful, politically unsustainable, and costly in terms of growth impact when the time comes to restore low inflation.

A much better strategy for macroeconomic policy is to devote monetary policy to one task: that of delivering low and predictable inflation. This is what all mature market economies do.

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