A recurring dilemma called rate hike

Economic data, in the best of times, tend to throw up a number of contradictory trends. For the decision maker, who looks at this data and weighs the pros and cons of various courses of action, it often boils down to a judgement call.

For the RBI Governor, this is a dilemma he has to confront every 45 days. There is one set of data that would point to a hike in interest rates. And another set militates against this course of action.

So, in the first category, you have factors such as a high inflation rate which is above the comfort level of 5 per cent, a fairly high credit growth rate that is again beyond the targeted growth rate, higher money supply, et cetera — all of which would probably suggest the prescription of a higher rate.

In the second category of factors that would argue for a pause in rates, you have weak global economic outlook, the volatility in industrial production numbers, the slowing down of economy as reflected by lower growth in GDP numbers over the last two quarters as well as the advance tax numbers that are below targets.

To add to the confusion, consider that the integrity of the data itself is often suspect and the fact that inflation is greatly influenced by supply shortages in food sector, and that monetary policy action can do little about it.

Besides, monetary policy has a safe-harbour clause that it works only with a lag — anywhere between 12 months and 18 months — according to experts. So, you can't really say whether a variable is reacting to your latest hike or the hike that you effected one year ago.

In this pull of various factors in an environment of continuous uncertainty, the RBI Governor has to take a call on interest rates — and even then, with no guarantee of getting it right.

You can almost compare it to adjusting your bathroom shower to give you the right bit of warm water. Turn the hot water tap a little more and you get scalded. Turn the cold tap a little more and you freeze in the chill. Finally, after a lot of trial and error, you get it almost right — and it is time to step out of the bath — with either burns or chills, or both. Substitute the economy here — and so you have some parts that get scalded and some parts that manage to survive.

The RBI had the option of delivering a 50 basis point rate hike, as some experts suggested, and delivering a strong anti-inflationary signal to the economy. Or it could have chosen to pause and wait for the next quarter. It has chosen to stay on the tightening course and go for its usual ‘baby step' increase. This, however, runs the risk of leaving the door open for further hikes; and the market will factor this uncertainty.

Banks have so far transmitted the policy signals by effecting their own round of hikes. This time, however, one wonders if they will be able to pass on the hikes to customers who are already groaning at an almost 500 basis point hike in effective rates over the past two years. May be it is the banks who will pause now.

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