Monday, August 2, 2010

RBI Move Caught between Hawks and Doves

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In line with policy normalization to pre-crisis levels and to fight continuing inflation pressures the Reserve Bank of India was expected to raise policy rates yet again in its First quarter Review of Monetary policy for fiscal 2010-11, however, the exact amount of tightening seems to have displeased both the Hawks and Doves. The RBI’s July review of monetary policy had three focal points — the central bank raised short term lending or the repo rate by 0.25 percentage points to 5.75 per cent; the short-term borrowing or reverse repo rate has been hiked by 0.50 percentage point to 4.50 per cent; and the cash reserve ratio or CRR and bank rate have been kept unchanged at 6.0 per cent. RBI has apprehended inflation and growth concerns and tried to balance them out and raised the repo rate to signal its hawkish bias to tame inflationary expectations, while it switches to a liquidity injection mode whenever there is a pressure on overnight rates. The asymmetric hikes in rates which leads to a narrowing of the corridor between the borrowing and lending rates is to signal the central bank’s desire to cut down volatility in short-term rates. The CRR has understandably been kept unchanged as bank deposits have not grown sufficiently in the low interest rate scenario and thus it may not be sensible to further reduce the lending ability of banks. The increase in bank deposit rates is expected to raise banks’ deposit accumulation and help to transmit monetary policy with a lag when they start raising lending rates thus moderating fund flows to particular sectors which are in danger of over-heating.

However, the Hawks blamed RBI for not doing enough to tackle inflation — especially given the fact that growth expectations are now higher along with emergence of clear demand side pressures on inflation — a 25 bps hike was clearly thought to be inadequate. Combined with an existing scenario of negative real interest rates RBI’s stance was not considered to be at par with a central bank dedicated to maintaining an inflation target. Doves on the other hand feel that given the uncertainty of global economic recovery and the infrastructure bottlenecks faced by the Indian economy, the cumulative 50 bps repo rate hike in the month was a bit steep and could destabilse the growth momentum, an apprehension not entirely unjustified, given that May IIP growth was significantly lower than preceding months, followed by June Core sector figures which were also lowest in a number of months. Not to forget the main supply side pressures on inflation created by tremendous amount of infrastructure investments still needed to strengthen agriculture and distribution mechanisms within the country. In fact the RBI brought a deluge on to itself as it said that the rains would impact inflation; however, we forget two things— it is not entirely the central bank’s fault that we still do not have enough infrastructure in place so as to not allow Rain Gods to set our inflation trajectory and also international commodity (say fuel) prices are still very much dependent on the amount of snowfall the West receives.

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