The Hindu Business Line : Have interest rates peaked in India?

That is the key question engaging the minds of all economic agents. Reports about commercial banks starting to lower their deposit rates — particularly on wholesale bulk deposits — are the first, though tentative, signs of a softening of interest rates. Coming just a few weeks before the Reserve Bank of India’s first quarter Review of Monetary Policy, these signals have made more significant what the RBI would come up with on July 31.

Will the central bank give its seal of approval to the gradual winding down of interest rates on the back of the monetary tightening measures it has put through in the past several months? Or will the RBI feel that it may be premature to declare victory over inflation and so would take further measures (not necessarily rate hikes or liquidity restricting measures) to sustain the progress towards lower interest rates?

Inflation control dominates

Inflation-containment has emerged the pre-dominant policy objective in recent times, scoring over the central bank’s other responsibilities with regard to ensuring adequate credit/sustaining the economy’s growth momentum. This shift or re-balancing of priorities has been somewhat unanticipated, so that some of the central bank’s policy moves in the past couple of years have packed a lot of the surprise element.

It is one thing for the market to anticipate a particular central bank action/policy stance and position itself accordingly in terms of assets, liabilities or more broadly business numbers. That way, the central bank also could possibly achieve what it seeks to achieve by actually doing less than what is originally intended. For instance, if the market pushes up short- and long-term interest rates in anticipation of central bank tightening, the central bank may possibly have to tighten by less than originally planned.

It is another thing when the central bank’s policy moves are unanticipated. The surprise or shock element (in terms of the magnitude and timing of the move) then carries a lot of punch. Such interest rate surprises or shocks, though, seem to have had the desired results if the on-going trends in the inflation numbers are any indication. There has been a distinct softening in the inflation numbers in recent times. From a year-on-year rise of as high as 6.75 per cent as of February 3, 2007, the year-on-year rise as of June 9, has dropped sharply to 4.30 per cent. What is more encouraging than these point-to-point yearly comparisons is that the month-on-month numbers are also showing distinct softening signs. If the recent softening in the month-on-month numbers can be sustained into a trend, we would well have seen the peak in the current interest rates cycle.

Softening numbers but some caution…

As the Table shows, from a high of 6.73 per cent as of February 3, 2007 (that is, the rise in the WPI between February 3, 2006 and February 3, 2007 is 6.73 per cent), the WPI number has dropped to 4.30 per cent as of June 9, 2007. And contributing significantly to this trending down of inflation is the much lower level of month-on-month changes seen in the Wholesale Price Index this calendar so far — particularly the past four months. It can be noticed from the Table that compared to rises ranging between 5 per cent and 17 per cent (annualised monthly changes) in the WPI the previous year, the WPI is rising at a much lower level currently on a month-on-month basis.

To be sure, there is considerable volatility in the month-on-month numbers also. For instance, the annualised change in the WPI in April 2007 over March 2007 was as high as 9.30 per cent whereas it has been much lower in the other months. That is something one has to be cautious about.

Softening more than due to base effect

What is positive about the inflation come-down is that it is not merely a base-effect induced phenomenon. There appears to be a structural decline in prices at the wholesale level. The lower level of month-on-month changes in the inflation index is the key and attests to that structural softness which is setting in. For, if the month-on-month changes were to follow the pattern of the previous year, the year-on-year numbers would still be much higher than they are currently and there would not be any (beneficial) impact from the much higher base of the previous year. Indeed, the base is not exactly significant except to provide a reference point from which the current level of inflation can be measured. It would be, therefore, critical to sustain this month-on-month decline and also smoothen out the volatility that has been witnessed in this series.

Policy signals

The deceleration in the month-on-month changes signals that the RBI may possibly be on hold in the upcoming Monetary Policy Review. No change in the key money market intervention rates such as the repo/reverse repo and also no change in the reserve ratios is what one can expect. In the interim, one has to be prepared for more that the RBI is currently offering — little or no forex market intervention which will slow down the growth of reserve money which in turn will impact the growth of overall credit/money stock.

The volatility in money market rates in the recent past is something one has to be cautious about. That could possibly have the potential to skew the month-on-month inflation numbers. Global monetary (policy) developments also have to be reckoned with in framing a local interest rates view. With the US Fed on hold but rates moving up in other key G7 markets, there could be a broad balance towards keeping rates on hold here also. Energy prices may have the potential to upset this movement towards lower interest rates and should be a factor to watch out for.

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