Staying 'calibrated'

MID-TERM REVIEW OF ANNUAL POLICY 2004-05/ GUEST WRITERS: DOMINIC PRICE

Dominic Price

The hike in the repo rate by 25 basis points to 4.75 per cent signals a shift in its growth-inflation tradeoff. The increase follows a hike in the cash reserve ratio in August, which was the first sign of the RBI moving to a tightening bias, and demonstrates the RBI's confidence in the ongoing industrial recovery.

The revised forecasts for GDP and inflation appear credible; the reduction in the growth forecast owes to a poor monsoon season rainfall and rising oil prices.

While the RBI acknowledges the impact of higher commodity prices on inflation, it is also cautious on demand-driven inflation pressures that are beginning to make their presence felt, and, accordingly, has acted upon the need to contain inflationary expectations. Encouragingly, the central bank is mindful of any delay in action that results in a stronger response at a later time.

The RBI statement suggests that the central bank will remain "calibrated" in its approach, while stressing that it would ensure the provision of "appropriate" (changed from "adequate" in the last statement) liquidity. J P Morgan maintains its call that the RBI would raise rates by 25 basis points again in early 2005.

In part, our view reflects our belief that the economic recovery is broadly based and has gained considerable momentum; fears that gradual monetary tightening will derail the recovery are significantly exaggerated.

In addition to the risk of more RBI tightening in the future, interest rates will remain under pressure from resurgent credit demand, slower inflow of foreign capital, and the continued need of the government to fund its budget deficit.

In this regard, it is imperative that the government's deficit targets be met "" note that as yet the government has completed only 29 per cent of its borrowing target for the current financial year.

Further, banks' investment patterns will continue to de-emphasise government bonds and will add to the upward pressure on bond yields.

Finally, the decision to raise the risk weight for housing loans and consumer credit "" the fastest growing sectors for credit in recent times "" as a temporary counter-cyclical measure of risk containment must be applauded.

Although this move may nudge borrowing rates for individuals higher, it is a prudent pre-emptive measure to ensure against the bunching of risk from this account.