The Hindu Business Line : Political economy of interest rates

For several weeks now, bond yields have been rising sharply, with 10-year G-Secs peaking at nearly 7 per cent. Thus, the repo rate hike in Monday's Mid-Term Review of Annual Policy for the year 2004-05 was no surprise. In fact, it was the sudden increase in the CRR a little while back that caught the market on the hop, coming, as it did, on the heels of a big (and unexpected) bond rally, which pushed yields on 10-year gilts to as low as 5.87 per cent from 6.75 per cent.

The extremely well-written review of macroeconomic and monetary developments makes several important points. The central bank continues to be extremely concerned about inflation, revising its expectation significantly upward to 6.5 per cent from 5 per cent. At the same time, disturbingly, it projects lower growth of 6-6.5 per cent, taking into account the somewhat inadequate monsoon, which will affect agriculture.

The liquidity overhang finds mention at several places and is seen as a potential source of price pressures. Credit has picked up smartly and resources flowing to the commercial sector increased substantially - evidence of the real economy gathering momentum.

The divergence between the WPI and CPI - with the latter offering a much more sanguine picture of inflation - remains a puzzle to the RBI. Seemingly, the devil lies (or does not lie) in the statistics.

Taking a deep breath, the central bank has chosen to raise its repo rate from 4.5 per cent to 4.75 per cent - an increase of 25bps and a sort of "market lot" for central banks the world over.

Obviously, the surge in global oil and commodity prices has played no mean role in rising inflation. But the pattern of Indian inflation has distinctly changed.

In the days of yore (read pre-liberalisation), it was led by increases in the prices of products of mass consumption. Today, the story is different. The common man does not seem be much touched by all the noise being made about inflation.

In fact, the most exercised (and possibly the least-affected!) are policymakers and the financial community.

On inflation prospects, the undertone of the RBI is gloomy. It is more or less clear from the Policy that further rate hikes are in store.

Will they affect growth and investment? The rates of return in well-run Indian companies are in the range of 15-20 per cent, so an increase of 1-1.5 per cent in interest rates will not affect them much and may be made up with cost savings and better productivity.

Actually, contrarian thinking might even dub raising rates "populist", because it benefits a vocal, opinion-driving class, comprising employees in the organised sectorand the retired whose income is entirely at the mercy of bank deposit rates that have fallen more than half in recent times. This group is likely to welcome moves to higher interest rates. Raising interest rates need not be vote-losing propositions.

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