Millennium Post

RBI rate hike to dampen growth

The point to note about the Reserve Bank’s new credit policy announcement is that it has virtually adopted the Urjit Patel Committee recommendations on monetary policy making.

A committee to review and recommend monetary policy formulation under the chairmanship of Urjit Patel, deputy governor, RBI, had recommended recasting the way monetary policy was formulated in India. The committee suggests that RBI’s basic policy rate should always be positive. The committee further observed that the retail inflation measure – CPI – should be considered for monetary policy making and that this should be targeted to brought down to  four per cent, with a band of plus/minus two per cent by 2016. But in view of the high level of CPI inflation, the target should be achieved in phased manner and for next 13 months till 2014 January inflation should be targeted at eight per cent.

Indeed, this has put RBI’s credit policy making into a cast iron mould. Interest rates have to be positive, that is, above the inflation rate. Inflation targeting was the prime objective of the central bank. Growth concerns can be noted but need not be acted upon.

Without this perspective, RBI’s policy moves and its policy statement and review of the macro economic situation are at variance. This is how. RBI has stated that industrial activity remains in contractionary mode mainly on account of manufacturing which declined for a second month in succession.   Consumption demand continues to weaken and lacklustre capital goods production point at stalled investment demand. RBI fears that this should further worsen in case of fiscal squeeze in the third and final quarters of the financial year. Thus, aggregate demand should be go down.

In a macro economic environment like this, RBI has chosen instead to further raise interest rate and pursue a contractionary monetary policy. This is all in the name of containing the inflation expectations.

Now, will repo rate hike and higher lending rates of commercial banks really bring down the prospect of onion and vegetable prices coming down. Will such a policy convince the vegetable growers, middlemen and the ordinary consumer to believe that prices should stabilise and not rise any further.

Maybe, these measures (dearer money) should convince the investor that this was not the time to invest. The house buyers might get frightened about the loan instalments on money borrowed to buy house property. Loan finances from banks for purchase of consumer durables might best be avoided.

The consequence would be a further fall in investment, in housing demand, in purchases of consumer durables. These industries already suffering from low demand and weak market conditions, should cut back production. Maybe, these prices might come down a bit.

Will such a policy really anchor inflationary expectations at a lower pitch. That might happen for consumer durables but might not affect a wee bit the prices of food articles. And what has been driving inflation are the prices of food articles. But why such a posture is taken? Because the Urjit Patel committee now suggests that inflation control should be the prime objective, that interest rate should always be positive and above inflation and we must bring down inflation rate to eight per cent by January next year. No matter happens to the economy in between. The pundits say that low inflation is good and such a thing should encourage investment. But what about high interest costs and slowing down of the economy.Given the defiance of food inflation to interest rate policy, such an approach will not cool down inflation, but instead clamp up the entire industrial sector and bring about a slump in demand.

In fact, RBI’s inflation targeting should take into account core WPI inflation rather than CPI inflation. It is core WPI inflation which directly responds to interest rates and was much more amenable to policy responses. CPI inflation, which gives predominance to food articles inflation, has far greater dependence on government moves. Basic factors about food inflation are the MSP announced annually or the restrictions on movement of farm, apart from secular rise in food demand.

A more flexible inflation targeting may be more useful, keeping in mind the growth performance of the economy. Indeed, during the time the economy was growing fastest, we had seen inflation at sub-four per cent level for some time. Such a mechanistic approach will insulate monetary making from ground reality and from the imperatives of growth in a developing economy. In a way, the administrative structure and norms based approach suggested would make monetary policy making in India a replica of US or UK practices. Such an approach might not always be suitable for India. Given the structural nature of Indian inflation with food prices rising for the better part of last three years, a monetary policy regime suggested in the framework of the Urjit Patel committee would be too harsh for growth. In case of India, it looks as though better farm production, particularly of vegetables and protein items, was the best insurance for price stability.

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