A rate hike, by
Reserve Bank of India, or RBI, at its First Quarter Review of Monetary Policy for 2011-12, was not ruled out. But a 50 basis point hike (a hundred basis points make a per cent) in the repo rate, or the rate at which the central bank lends to other banks, came as a surprise. The eleventh rate hike by RBI since March 2010, this hike was expected to follow the RBI's pattern so far of raising the rate in 'baby steps' of 25 basis points.
But the larger rate hike along with a few caveats in the policy statement, send a few clear messages. On the one hand, RBI's monetary policy aims 'to maintain an interest rate environment that moderates inflation and anchors inflation expectations,' and on the other hand, aims 'to manage the risk of growth falling significantly below trend'. So the message, coupled with the larger rate hike, is clear: RBI will not tolerate increased inflation.
Clearly,
inflation is the bigger demon for now, and some growth trade-off is very much in RBI's cards. Also, RBI has held that stronger monetary policy actions are required. So further rate hikes shouldn't be ruled out, especially if inflation doesn't moderate.
The bank says it considered both inflation and growth before the policy move. "Demand pressures have remained strong," says RBI. Quoting its annual monetary statement from May, RBI pointed out that inflation was expected to remain elevated in the first half of 2011-12. "Actual inflation so far has been even higher than expected." Non-food manufactured product inflation, in particular, has been significantly higher than the average rate of 4 per cent over the last six years. Also, crude oil prices remain volatile and pose a major risk. "The recent increase in domestic administered fuel prices and the minimum support price for certain food items will also keep inflation under pressure," RBI added.
READ how you can deal with rising interest rates and still get that loan Then there are signs that growth is beginning to moderate, particularly in some interest rate-sensitive sectors. "However, there is no evidence, as yet, of a sharp or broad-based slowdown," says RBI. Several indicators such as exports and imports, indirect tax collections, corporate sales and earnings and demand for bank credit suggest that demand is moderating, but only gradually, RBI pointed out.
The larger inflation picture appears on the global canvas. In RBI's own words: 'On the global front, the sovereign debt problems that have beset the euro area over the past year now threaten larger economies in the region. There is heightened anxiety about whether the euro area will be able to agree on an economically viable, fiscally sustainable and politically feasible solution to the vexing sovereign debt problem. In this regard, the agreement reached by the euro zone leaders in their meeting on July 21 is a positive development. However, its effective implementation remains to be seen. In the US, concerns over a sovereign default loom over financial markets, with potentially disruptive consequences for global capital flows.'
"From the perspective of India's macroeconomic policy imperatives, a critical consideration is the effect that global conditions will have on commodity prices," RBI highlighted. After RBI's May policy statement, the prices of many commodities, including that of crude oil, showed signs of softening, reflecting weakening demand in advanced economies. "Had this trend consolidated, it would have provided some welcome relief from inflationary pressures," says RBI. "However, one quarter later, the downtrend has not yet proved to be very strong," RBI added. Prices are generally still high compared with a year ago.
READ:
Rate hike alone cannot battle inflation, says KV Kamath With no immediate prospects of monetary tightening in the advanced economies, the impact of weakening demand appears to be offset by that of abundant liquidity, RBI points out. And if US comes up with a third round of quantitative easing, it would bring about a boomerang in commodity prices.
Based on the assumption of a normal monsoon and crude oil prices averaging $110 per barrel, RBI in its May policy statement projected baseline real GDP growth for 2011-12 at around 8 per cent. A substantial jump in global crude oil prices would mean a reset in India's GDP growth. The bank RBI has put it in black and white: "It is important to recognise that in the absence of appropriate actions for addressing supply bottlenecks, especially in food and infrastructure, questions about the ability of the economy to sustain the current growth rate without significant inflationary pressures come to the fore."
And towards the end, RBI is vocal about the fact that its efforts to achieve low and stable inflation could also be supported by concerted policy actions and resource allocations to address domestic supply bottlenecks. "The challenge for the Government and the Reserve Bank is to ensure that demand is constrained in the short term to bring inflation down, but to encourage supply response so as to expand the potential output of the economy in the medium term," says RBI.
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