Raised rate, lowered sentiment

| Updated on March 12, 2018 Published on January 28, 2014

Raghuram Rajan’s surprise repo hike is ill-timed

In his last mid-quarter policy review on December 18, the Reserve Bank of India Governor Raghuram Rajan surprised almost everyone by not hiking interest rates despite the consumer price index (CPI) inflation hitting a record 11.16 per cent in November. He gave two main reasons for not doing so. The first was the “weak state of the economy”. The second pertained to the “merit in waiting for more data”, especially taking into account “indications that vegetable prices may be turning down sharply”. On the data front, the governor was absolutely right. Not only did retail inflation in December fall to 9.87 per cent, vegetable and fruit prices are registering “disinflation”, as the RBI’s policy review has pointed out. As for the state of the economy, Rajan put it most succinctly: The slowdown is getting “increasingly worrisome”, with industrial activity in “contractionary mode” and lead indicators of services also suggesting a “subdued outlook”.

Despite all of this, the governor has, rather than lowering or retaining the RBI’s benchmark repo rate at the current level, chosen to raise it by 25 basis points to 8 per cent. This is unwelcome and a departure from the central bank’s own position in December that was sensitive to the risks to growth from taking an “overly reactive policy action”. Those risks, if anything, have only gone up now even as inflation pressures are receding courtesy a bumper rabi crop. The rate hike, moreover, sits uneasily with a Centre that is simultaneously resorting to fiscal tightening, which, by the RBI’s own admission, is “likely to exacerbate the weakness in aggregate demand”.

One reason why the RBI may have opted for a rate increase is to signal acceptance of the Urjit Patel committee’s recommendation of making CPI inflation the nominal anchor for monetary policy formulation. But the Patel panel had warned against the “output costs of disinflation”, while setting a one-year time frame for bringing down retail inflation rate to 8 per cent. Given that food and fuel have a combined weight of 57.1 per cent in the CPI — and the RBI has little control over their prices — it is debatable whether a repo rate increase is going to have any effect on inflation 12 months down the line. What will matter much more is the behaviour of the south-west monsoon. It is also doubtful whether higher interest rates will help contain inflation in the short term; therefore, those who think that a hike may help the UPA’s chances in the next Lok Sabha election are harbouring a false hope. But they are certainly not going to help lift investor and consumer sentiment either. The fact that “further policy tightening in the near term is not anticipated at this juncture”, as the RBI governor has assured, is the only consolation.

Published on January 28, 2014
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