Monetary Policy review: Big deal?

Source: EM

“There have been three great inventions since the beginning of time: fire, the wheel, and central banking,” quoted Will Rogers. Probably, no other quotation would exemplify the importance of central banking more than what has been said above. Especially in these times, when global economies and their financial systems look more integrated than ever before, there has been a constant pressure on central banks worldwide to adjust their policies to global developments. And this has promoted the chiefs of central banks worldwide to the position of demigods’ for the economy whose policies could have a lasting impact on growth and development.

A clear example of global economic and financial integration has been seen in the past two months. In wake of rising inflation (and inflationary expectations), worries of higher interest rates have fueled high levels of volatility in stock markets around the world. The fear is that if interest rates go too high, it could consequently lead to deceleration of the global growth engine, or even lead to a worldwide recession.

As Dr. Y.V. Reddy delivers his first quarterly review of the Monetary Policy for 2006-07 later today, all eyes will be set on ‘the stance’ of the review with respect to the benchmark interest rates. Will he do a Bernanke (raise rates further) or will he give some more time to himself to take a look at the real state of the Indian economy and the global economy before taking the next step.

Factors in favour of interest rate hike:

  • RBI needs to follow global cues (read, US, Japan, Europe and more!). Especially when the US Federal Reserve has not given any ‘concrete’ outlook with respect to stopping its ‘measured’ pace of rise in interest rates, how can the Indian central bank take rest? This is because if the gap between the US and Indian rates narrows, Indian markets might witness a further capital flight. Since the beginning of May 2006, the Indian equity markets have witnessed net FII outflows of US$ 1.6 bn.

  • Sharp depreciation of the rupee in the wake of increasing current account deficit (Rupee has depreciated against the US$ by around 4% since April 24 2006). Further depreciation of the Rupee will lead to more expensive imports. This might add up to the headline inflation in the economy.

  • Economics suggest that if a country’s GDP growth rate is higher than the benchmark interest rate for a longer period of time, it might result into an overheating situation. Real GDP growth rate of over 6% and real interest rates at near 3% thus warrant a rate rise. (Real interest rate = Nominal interest rate minus inflation).

Factors not favouring an interest rate hike:

  • As per CMIE, the major reason for inflation (apart from the recent rise in food prices in India) is the sharp rise in commodity prices globally. In simple terms, it is the supply-related issues that are fuelling inflation. By raising interest rates in India, these supply-side issues will not be addressed in totality (take the case of crude prices), as these factors are governed by the global demand-supply equation. To quote CMIE, “we believe that any reduction in excess liquidity by the way of hike in interest rates would not help reduce the demand for these goods, as these are daily consumption items. They would continue to be consumed inspite of a rise in their prices.”

  • More importantly, any rise in cost of funds might dampen the spirit of India Inc. that has been borrowing aggressively to expand operations.

Considering these factors, while many expect the RBI to increase interest rates, as per the latest economic issue from CMIE (a economic research company), it does not foresee a need to increase interest rates. To quote the report from the research agency, “We believe that there is no need for hike in interest rates in the near future as any hike in interest rate would not help curb inflation but adversely affected the economic growth.” As for our view, we expect interest rates to increase (whether now or in the interim as had happened the last time around) during the course of the fiscal.

Well, whatever be the central bank’s decision this time, it would be indeed a tough one. Tough because if the bank decides to raise interest rates now when the Indian economy is looking like stepping on a higher growth trajectory, it might act as a dampener to prospects. On the other hand, if the bank does not raise the rates, it would be in a tight spot over inflation that has been rising, one major reason being sustenance of high crude oil prices. Over to Dr. Reddy!

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