Well-crafted monetary policy

The RBI Governor, Dr D. Subbarao's Monetary Policy announcement on July 26, is one of the very best policy statements from the Reserve Bank of India in recent years. The policy is unswerving in its anti-inflationary stance and the guidance is unequivocal. The policy does not look for kudos but is focused on RBI's dharma of inflation control.

Expectations that inflation would taper off have been belied and, therefore, the RBI has prioritised inflation control, overriding all other objectives. The GDP growth in 2010-11 is estimated at 8.5 per cent and, in all probability, this estimate would undergo an upward revision. Thus, growth is exploring its limits.

HIKE NOT EXCESSIVE

The current inflation rate is, however, a great worry and embarrassment to the RBI, with a year-on-year increase at the end of June 2011 of 9.4 per cent. The revised number could well end up in double digits.

As against the earlier projection of inflation at the end of March 2012 of 6.0 per cent, the RBI has now had to raise this to 7.0 per cent, and there are fears that if domestic and international conditions turn unfavourable, the inflation rate at the end of March 2012 could be much higher.

The current inflation rate is way above the RBI's comfort zone of 4.0-4.5 per cent. Furthermore, the inexorable integration with the world economy would require that in the medium-term, the RBI would need to work towards a much lower inflation rate of 3.0 per cent.

The RBI has taken a bold step to raise the repo rate from 7.5 per cent to 8.0 per cent and the Marginal Standing Facility rate from 8.5 per cent to 9.0 per cent.

This measure would not go down well with India Inc. as well as banks. But while any borrower would like to get credit as cheaply as possible, it needs to be recognised that the 0.50 per cent increase in the repo rate would not be disruptive.

The average interest cost in industry is around 10 per cent of total costs and an increase of 0.50 per cent in interest cost would raise overall costs by 0.05 per cent.

In the case of interest-sensitive sectors, let us assume that interest cost is 20 per cent of total costs; a 0.50 per cent rise in interest cost would raise the overall cost by 0.10 per cent. Thus, the overall impact on total costs would be insignificant.

As a general rule, banks are more comfortably placed when interest rates are rising than when they are falling. This is essentially because the increase in interest cost impacts faster on average effective lending rates than on average effective deposit rates; the reverse applies when policy rates fall. It is paradoxical that banks moan when policy rates rise and make merry when policy rates fall!

ENTRENCHED INFLATION

Many policy observers have pointed out that when deposit rates are higher than the RBI policy rate, the RBI becomes the lender of first resort rather than the lender of last resort, as it should be. Thus, in the current Indian context there was an obvious case for a rise in the policy rate.

The RBI has indicated that it would review policies if the growth rate and the inflation rate fall precipitously. There is, however, only a remote possibility of the growth rate falling below 7.5 per cent in 2011-12 and the inflation rate falling below 5.0 per cent.

The fear, if any, is that the inflation rate would be uncomfortably high as reflected in the RBI's projection for March 2012 of 7 per cent.

Market players need to appreciate that the present repo rate of 8.0 per cent cannot be the end of the policy rate increases.

Global uncertainties, the monsoon and other domestic uncertainties point to the fact that the policy interest rate would need further increases in September and October 2011, particularly as inflation is getting wedged in strongly, and the longer one waits the more difficult it is to eradicate inflation from the system.

The policy statement makes an important point that in the last decade, the average inflation rate had moderated to around 5.5 per cent. Given the present unacceptable inflation rate, the RBI has reiterated its strong view that controlling inflation is imperative both for sustaining growth as also increasing the potential for growth in the medium-term.

While the policy measures and their articulation are par excellence, we need to give some thought to the use of a measure which would render the monetary policy more effective.

The RBI could have considered a moderate increase in the cash reserve ratio (CRR) which would then have eased the pressure on the interest rate instrument.

It is important for market participants to understand and appreciate the thrust of the July 26, 2011 policy, as it would be a watershed in the emergence of monetary policy as an effective tool of overall economic policy.

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