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| Policy rate hike by RBI: To what extent? |
| Arun Singh / New Delhi May 20, 2011, 16:51 IST |
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 Persistence of high inflation at a time when India is on the verge of achieving pre-crisis growth levels, continues to be the cause of concern for the common man and the government. The fact that price pressures which had originated in the food segment owing to supply side bottlenecks had shifted to non-food products indicating demand side pressures, has further added to the difficulty of managing inflation by the government and RBI.
Currently, a number of risks have the potential to fuel inflation in the near to medium term. Uncertain outlook due to geopolitical tensions in the MENA region and possibility of global commodity prices especially food, minerals and metals, staying firm in the near future has increased the upside risks to inflation. Moreover, the sustained, elevated level of global crude oil prices which has led the government to go ahead with a sharp hike in the petrol prices, with an expected increase in the LPG and diesel prices anytime soon will definitely lead to a rise in headline inflation in the coming months. These, along with other factors such as second round impact of hike in fuel prices on the food, manufactured and wage inflation; which is yet to unravel, and the still incomplete pass-through of the global fuel prices in the administered as well as the non-administered domestic fuel prices also raises concerns.
Clearly, a high growth level in an economy is not sustainable under a high inflationary situation; as a sustained increase in prices tend to derail growth in the medium to long run by impacting both consumption as well as investment demand. In accordance, the RBI had begun its accommodative monetary policy stance since March 2010, when inflation had reared its head to touch double digit growth rates. The RBI had gradually tightened its policy rates since then, though in small quantum. During the period Mar 2010 to Mar 2011 RBI had raised the repo rate by 200 basis points (bps) and the reverse repo rate by 250 bps in 8 tranches. Further, the RBI in its Annual Monetary policy review on May 3, 2011 resorted to an aggressive policy rate hike by increasing the repo rate by another 50 bps, when a number of indicators were already showing signs of moderation in the investment activity in the economy. The repo rate currently stands at 7.25% and the reverse repo rate stands at 6.25%.
The question that arises here is - how far the central bank should go ahead before taking a pause with regard to tightening itspolicy rates? Given that the inflationary pressures in the economy would continue to persist for some more time, we expect the RBI to maintain its monetary policy tightening cycle. However, the magnitude of the increase would vary on how the inflation pans out in the near to medium term. If inflationary pressures continue to remain at the current levels with no major upticks from the international commodity prices including oil, we anticipate an increase of another 25-50 bps in the policy rate. However, if the commodity prices trend upward from the current level, it would put further pressure on the manufactured products inflation which would then warrant further aggressive policy tightening. In case such a situation prevails, we expect a hike in the repo rate by around 100 bps. Although the RBI has been incessantly raising its key policy rates to fight against inflation, the policy rates still remain below the levels reached during the pre-crisis period. Nonetheless, going ahead, such high interest rates would not only help in tempering inflation expectations but would also curb the demand side pressures especially, investment demand. In such a scenario, the consequent moderation in the investment activity might restrain the GDP growth during the year.
(The author is Senior Economist, Dun & Bradstreet India)
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