Change of stance

The Reserve Bank of India's mid-term review of monetary policy marks a subtle but firm change in the central bank's stance on interest rates. Earlier, the RBI had shown a marked reluctance to raise interest rates, in spite of the sharp rise in inflation, on the valid grounds that the inflationary shock was not the consequence of excess demand.

A small breach in that stance had been made when the RBI raised the cash reserve ratio recently, but many market players believed even that move was proof of the central bank's reluctance to raise interest rates.

Raising the repo rate by 25 basis points, therefore, marks a crossing of a mental Rubicon by the RBI.

The change of stance is contained in the language of the review: while the annual policy statement of May stated that the overall stance was "provision of adequate liquidity to meet credit growth and support investment and export demand in the economy while keeping a very close watch on the movements in the price level", the mid-term review states that the stance is "provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability".

The change from "adequate liquidity" to "appropriate liquidity" and the emphasis on price stability signals, in centralbankspeak, a subtle yet firm shift in stance.

Two or three additional factors seem to have influenced the RBI. There is the rapid growth of credit, which has been galloping along faster than expected.

Second is the lowering of overall growth expectations for the year, though it can be argued that the initial assumption of 7 per cent GDP growth was always optimistic. And third is the unstated desire to cool the market for personal loans (primarily for housing and cars)""hence the increase in their risk weight.

This signals to banks that they should start nudging up the interest rates on such loans""which is as it should be, given the rise in delinquency rates on such loans.

In view of all these considerations, the 25-basis-point increase in the repo rate is an exercise in moderation, and signals the RBI's continuing awareness of the need to avoid choking growth impulses.

It could be argued that since bond yields have moved up without any RBI decision to raise the repo rate, there was no need for the RBI to do anything as the market was making its own adjustments to emerging realities.

But then, not doing anything could have sent the wrong signals to the market, especially since the RBI believes that inflation""after factoring in the entire increase in oil prices""would be 9.3 per cent and not the current 7.1 per cent.

The RBI's view on inflation seems to be contrary to the view in New Delhi's North Block, from where there has been a stream of predictions that inflation levels will fall in the coming months.

The question remains as to whether such changes in the repo rate will have any effect, given the fact that so much of the rise in prices is globally driven.

Nevertheless, as the review points out, "It is also necessary to recognise the risks of stronger adjustments that may be needed if less than adequate adjustments are made at the appropriate time ..."

This hints at more interest rate hikes to come, especially since the RBI paints an encouraging picture of rising investment demand, good industrial growth, and growing exports. What has been announced this week is therefore just a first step.