While the Reserve Bank of India (RBI) had set the stage for a firm anti-inflationary stance in its quarterly macro-economic review released on Monday, yesterday’s repo rate and cash reserve ratio (CRR) announcements managed to surprise observers. There were widespread expectations of a 25 basis point hike in the repo rate (the RBI’s refinance window for banks), the CRR or both. These expectations had been moderated to a degree by the recent favourable developments on the oil price front, but the realists accepted that domestic price adjustments were far from complete even in the changed scenario. Given that the effect of low inflation rates in the second half of 2007 would push up rates this year through an adverse base effect, there was very little room that the RBI had for manoeuvre. Maintaining the status quo in this situation would have sent mixed signals on the significance of the inflation threat without necessarily doing anything to prop up growth in the immediate future. As this newspaper suggested in a pre-policy editorial, a clear and unmistakable signal on the RBI’s position was necessary at this point.
However, the 50 basis point hike is the second successive one of that magnitude, following the out-of-schedule hike last month, and seems to have surprised even the realists. At a time when all indications point to significant tightening of liquidity and a visible pass-through of higher interest rates to borrowers across the board, perhaps a 25 basis point hike would have been enough to convey the message and have the desired impact. The anticipated easing of liquidity as a consequence of a variety of factors in the next few weeks has, in any case, been addressed by the increase in the CRR taking effect in end-August. The larger-than-expected hike in the repo rate now raises concerns about whether the already moderating growth momentum will be affected even further.
One factor that seems to have influenced the RBI’s decision is the potentially destabilising impact of the widening fiscal deficit. Even as the macro-economic policy objective is to restrain demand in order to contain inflation, higher government outgoings in the form of salary hikes and the loan waiver go against the grain. Both are stimulants to demand, which can only aggravate an already delicate inflationary situation. With these already in the pot and perhaps more election-year largesse to follow in the coming months, the RBI presumably saw the need to exert a greater drag on demand than it otherwise would have done. In effect, the RBI has tried to offset fiscal developments that are contradictory to the current needs of the economy.
Only time will tell whether this move will prove to be costly. Meanwhile, the implications of these announcements for the policy stance in the coming weeks are that further hikes are less likely. If the decline in oil prices persists and the year ends with it being at around $100/barrel (which was the level in January), the RBI can shift unambiguously to a neutral stance for a while before beginning to reduce rates. If the relatively harsh measures taken in the last two months bring the opportunity to reduce rates forward by a few months, they will have been justified. However, global risks (principally oil prices) remain as undefined as ever, and could still spoil the party.
