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S. Balakrishnan

How much better would things have been had the RBI cut rates in the course of 2003!

OIL continues to set new records by the day. Last Friday, it was in whispering distance of $50 a barrel as Iraq and the woes of the giant Russian producer, Yukos, kept markets on tenterhooks.

Falling US inventories of crude and gasoline did not help matters. (Monday brought some relief: the resumption of Iraq's shipments and positive news on Yukos and Russian output pushed down prices).

The sharp rise in oil has not passed through to the US Consumer Price Index (CPI). While the Producer Price Index (PPI) - the measure of wholesale prices - reflects soaring crude, the CPI remains benign. Significantly, retail sales have eased and consumer confidence has suffered.

These suggest that rising energy prices have hit pocketbooks and lend credence to the view that the greater danger to the US economy in the current situation is recession and not inflation. In fact, the Federal Open Markets Committee (FOMC), which sets interest rates in the US, said in its customary post-meeting statement that the surge in oil prices set back business investments and hiring. But some economists think that crude could rise to $60 without a noticeable impact on growth prospects. Another reason why inflation has remained quiescent amidst higher energy costs is the rising productivity of US companies. This gives business the leeway and cushion to hold prices even when input costs go up.

The bond market agrees. As oil shot up, bond prices have followed suit. Yields on 10-year Treasuries are down to 4.25 per cent levels from a high of nearly 5 per cent. Two-year notes, which track likely Fed interest rate moves, yield less than 2.5 per cent, retreating from over 3 per cent.

India, as always, is a different story. The Government has cut import duties and taxes on crude and petroleum products as well as other commodities, such as steel, to curb inflation. It does not want the RBI to raise interest rates, except as the last resort.

How much better would things have been had the RBI cut rates in the course of 2003 to check capital inflows which were exploiting the dollar-rupee arbitrage. It is well known that much of the flows were driven by `hot' money out to make a quick buck. As the rupee could not be allowed to appreciate too much, the RBI intervened in the forex market to support the dollar and added to unwanted liquidity. In the process, arbitrageurs have made us at least a few hundred million dollars poorer.

A rate cut last year would have given the central bank more freedom to react to the current emerging situation of rising inflation and more important, inflationary expectations. A rate rise now would have been deemed an appropriate response.

More Stories on : Interest Rates | Financial Scan | RBI & Other Central Banks | Economy

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