The Reserve Bank of India's unrelenting focus on inflation was once again in evidence and not merely because it hiked the two short-term policy rates by 0.25 percentage-point each.
This move was widely anticipated and as the stock markets' muted reaction to the policy announcement showed, any other policy action, say, a higher 50-basis point hike in the repo rate, would have created a bigger impact. However, even if the RBI did not spring a surprise, its policy statement of November 2 is a mine of information on not just the monetary policy. As always, the RBI's detailed analysis of the monetary policy encompasses overlapping areas of the macro economy. Besides, its forecast of GDP growth is widely watched.
The central bank's preoccupation with price stability is not new. The earlier policy statements highlighted its role in combating inflation. The traditional monetary policy dilemma — of meeting the credit needs of the real economy while simultaneously maintaining price stability — has been in evidence. Recently, the RBI has been elaborating its monetary stance to include other related objectives such as financial stability.
The policy stance
This time, the policy stance is intended to (a) contain inflation and anchor inflationary expectations while being prepared to respond to any further build up of inflationary pressures; (b) maintain an interest rate regime consistent with price, output and financial stability and (c) actively manage liquidity to ensure that it remains broadly in balance.
The first objective captures the resolve of the RBI to focus on inflation while the second takes note of the fact that monetary policy cannot lose sight of other objectives. The third objective — of managing liquidity — is new to this policy statement. Excess liquidity will hinder transmission of monetary signals while a serious shortage will hurt credit offtake and financial markets.
There are several reasons explaining why inflation is such a major concern.
(a) Although there has been some moderation recently, the Wholesale Price Index-based inflation, 8.6 per cent in September, remains significantly above the target level of 5.5 per cent for March 2011.
(b) Despite a satisfactory monsoon, food prices have not moderated. Persistently high inflation, in such a situation, points to the existence of structural factors that cannot be tackled by monetary measures alone. These factors tend to heighten inflationary expectations.
(c) With the economy growing close to the target, the risks of inflation spilling over to other sectors is real.
(d) Global commodity prices, already high despite a weak recovery in the advanced countries, may rise further on the back of strong demand from the fast growing developing countries.
(e) The loose monetary policies pursued by the developed countries will flood emerging markets like India with surplus liquidity.
The RBI has retained its forecast of GDP growth at 8.5 per cent for 2010-11, which is entirely in line with most other forecasts. As with monetary projections, the growth estimates are subject to risks that are similar.
Interest rates
Too much has been read into the policy statement that “the likelihood of further rate actions in the immediate future is low.'' This has been interpreted to mean that the RBI has come to the end of the current interest rate cycle. Yet the policy statement is subject to numerous caveats. There can obviously be no commitment from the central bank to halt interest rate hikes, even for a brief period.
However, the RBI has increased the number of its policy statements to eight. The scope for announcing new measures in between two scheduled statement dates is limited. The next mid-quarter review of monetary policy will be announced on December 16 and the third quarter review on January 25, 2011.
Since the modest 0.25 percentage-point increase each in the repo and reverse repo rates was widely anticipated, there may not be an immediate move by banks to increase their lending rates. Besides, interest signals operate with a lag. Two relevant points are:
(a) Transmission of policy measures from policy rates to lending rates though improving is still dependent on some factors such as liquidity conditions. Tight liquidity improves transmission. The recently introduced base rate mechanism imparts transparency to the process of determining lending rates by banks.
(b) Bank depositors seldom get a fair deal in policy statements probably because unlike, say, organised industry, they do not have anyone who will lobby for their cause.
However, deposits with banks are not growing the way they should, mostly because they are giving negative returns. It is also fairly certain that household savings are being deployed in a wide range of non-monetary assets such as gold and real estate. However, for many categories of savers, bank deposits remain the safest option. It is time banking policy recognises this crucial role of deposits and not view them as something whose costs determine the lending rates.
