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Recognises the signs of a slowdown but says that it is essentially confined to sectors that are sensitive to interest rates |
Going by newspaper headlines and television commentaries, the larger than expected hike in the repo rate might seem to be the main, if not, the only noteworthy feature of the Reserve Bank's first quarter review of monetary policy. Before the policy statement, there was a near consensus among market participants that the RBI was nearing the end of its monetary tightening phase. Since March, 2010, policy rates have been raised by 425 basis points in ten instalments. Therefore, even though inflation has remained persistently high, the RBI will act by raising the rates but by not more than 25 basis points. Lending credence to the view has been the fact that there has been a slowdown and a steep hike in interest rates on top of the past cumulative monetary actions will be detrimental to economic growth. In short, the view among market participants was that the RBI would ‘pause' after taking another ‘baby' step, a 25-basis point increase. In that event, the 50-basis point increase has come as a ‘shocker'. Predictably, the stock markets tumbled. However, as always, it is difficult to attribute the steep decline in the indices to one factor alone. Global stock indices have been under pressure at the same time. The inability of the U.S. administration to reach an agreement with the Opposition over some critical issues of the federal budget has been the main cause for worry for the global stock markets. Returning to the monetary policy, it is likely that the RBI intended to spring a surprise. So persistent has been inflation that something out of the way was needed. In that sense, the larger than expected hike in the policy is akin to past RBI actions in announcing monetary measures in between two policy statements to catch the markets off guard. However, in those days there were four policy statements and the period between two statements was sufficiently long. The impact of an unexpected interest rate change would consequently be more on markets and intermediaries not expecting an intervention by the central bank. Nowadays, with eight statements in a year, the scope for announcements outside the scheduled policy dates has been reduced although there is nothing that prevents the central bank from doing so. The other more plausible explanation as why the markets were surprised by the large hike is that the participants simply misread the direction of the monetary policy over the recent past. Deputy Governor Subir Gokarn has said that there has been a decisive change in the central bank's monetary stance consequent to the change in the inflation trajectory. Inflation is not expected to come down. A mild policy response, which is also well anticipated such as a 25-basis point hike, will not help in moderating inflation expectations. Moreover, it is not as though the RBI has totally shunned hikes above 25 basis points. As recently as on May 3 at the time of the annual credit policy, the RBI hiked the repo rate by 50 basis points. Though focussed on inflation, monetary policy can never ignore economic growth. The RBI has recognised the signs of a slowdown but says that it is essentially confined to sectors that are sensitive to interest rates. There is no evidence yet of a broad-based slowdown. Several indicators such as exports as well as imports, indirect tax collections, corporate sales and earnings and demand for bank credit suggest that demand is moderating but only gradually. The above reasoning notwithstanding, the RBI's decision to stick to its growth projection for the current year at 8 per cent — first made in its May 3 policy statement — has come as a surprise. It is no surprise however that the year-end inflation projection has been marked up by one percentage point to 7 per cent. Inflation remains the dominant macroeconomic concern. Actual inflation so far has been even higher than expected. In particular, non-food manufactured product inflation has been significantly higher than the average rate of 4 per cent over the last six years. Crude oil prices remain volatile. The recent increase in domestic administered fuel prices and the Minimum Support Price for certain food items will keep adding to the inflationary pressures. The overwhelming emphasis on containing inflation is to be seen in the context of the traditional trade-off between growth and inflation. That the RBI has come out decisively on the side of inflation control has been well recognised for a long time and certainly since May 3 when the annual policy was announced. The government would play its role in tackling inflation through the quarterly review. Supply side initiatives, especially concerning food and infrastructure, have been mentioned as also reining in fiscal deficit. The burden on the monetary authorities is that much enhanced if the government does not do its bit. To quote from the policy review: One of the objectives is to “reinforce the point that in the absence of complementary policy responses on demand and supply sides, stronger monetary policy actions are required.''
HBL
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