With inflation troubling India’s central bank, its recent effort has been to use the monetary lever to dampen price increases. In its most recent monetary policy statement the Reserve Bank of India (RBI) raised the repo rate by half a percentage point (or 50 basis points) from 6.75 to 7.25 per cent. The central bank is clear about the intent of its manoeuvre. Its statement issued on May 3 notes: “Over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.” Not surprisingly, this is not the first time that the RBI has resorted to such a manoeuvre.

However, leaving aside the larger question as to whether monetary policy is the appropriate instrument to deal with the current inflation, there is an altogether different issue that the RBI’s action raises. Monetary policy normally seeks to affect real economic activity through two means. One is an increase in the cost of credit. The other is through restriction of the volume of credit provided.

What is noteworthy is that the RBI has not opted for measures such as raising the cash reserve ratio (CRR) imposed on banks in order to pre-empt lendable resources and restrict credit supply. This is surprising because world over an area of current concern is the sharp increase in debt resulting from measures used to address the recent economic crisis. Large volumes of credit were provided to and accessed by both the private sector (consisting of households and firms) and the government as part of the stimulus package. In India too, a major component of the stimulus was an increase in credit provision on rather easy terms.

Not surprisingly figures recently released by the RBI point to a spike in credit provision by the commercial banking system during 2009. Even though India was not affected as adversely by the crisis as were many other developed and some developing countries, the annual growth of credit provided by the banking system rose from 12.2 per cent at the end of 2009 to 26.6 per cent at the end of 2010. Related evidence quoted below suggests that a large share of this credit went to finance housing investments made by the urban middle class. As the accompanying figure shows, the resulting growth in scheduled commercial banks credit has been concentrated in urban areas, and especially in metropolitan centres.

Thus, the government sought to address the effects of the global recession by restoring the previously prevailing credit-financed boom that had been adversely affected by the liquidity crunch that crisis-induced capital outflows had generated. It needs to be noted, however, that this strategy has not been as successful as would be expected. Despite the spike in credit provision, manufacturing growth has remained sluggish, particularly during the November 2010 to February 2011 months.

One reason could be that the larger volumes of credit may have not meant much for the volume of housing demand, given the sharp increases in housing prices that have been observed in recent months. Going by a recent analysis by the Financial Times (May 23 2011) of the housing bubble in emerging markets, prices in Mumbai India have been rising even more steeply that in other EMEs.

This could explain the reticence of the central bank to interfere with the volume of credit provision. Fearful, perhaps of damaging the recovery, it is opting to merely tinker with interest rates in order to demonstrate its commitment to moderating inflation. But if credit is being substantially directed to those making housing investments, the interest rate hike may at best moderate housing demand and therefore the increase in housing prices. If the reason why the general price level, including prices of essentials like food, remains buoyant lies elsewhere, the interest rate hike is unlikely to be very effective.

The RBI’s move may even be counterproductive. Aggregate personal loans provided by the commercial banking sector are estimated to have risen by 17 per cent in 2010-11, as compared with 4.1 per cent in 2009-10. Within this category, the growth during 2010-11 in housing loans stood at 15 per cent and in loans against consumer durables at 22.4 per cent, as compared with 7.7 and 1.3 per cent respectively in 2009-10. Because of the periodic hike in interest rates, those taking on these loans would have in recent months been faced with significant increases in the equated monthly instalments they pay. This would not only discourage further borrowing and new borrowers, but can lead to defaults. Given the relatively high shares of personal loans in the aggregate advances by banks, this would discourage further lending as well. So a contraction of demand and growth is a real possibility, despite the RBI’s cautious manoeuvres.