RBI draws the pattern for FY11: Financial Express, 23rs April 2010

RBI has just about set the tone for the rest of the financial year by highlighting concern on inflation while being sanguine about growth. It has pitched a lower WPI inflation rate of 5.5% for the year on the assumption that the monsoon will be normal and the relentless pressure witnessed on prices last year will not recur this time. If one combines the high growth expectation of over 8% with an eye on inflation, it appears that RBI is speaking the Keynesian language of demand-pull forces that need to be tackled head on.
The 25 bps hike across all rates was a minor surprise because while the market expected an increase, it was pitched at a higher level of 50 bps. Considering that RBI has already increased rates in two phases in this calendar year, the approach may be seen as being gradual but more frequent. The markets should be prepared for further interventions, even between policies, and the WPI number will have to be actively monitored with negative real interest rates likely to prevail for some more time.
The inflation concern is palpable because there has been a shift from primary to manufactured products, and even within manufactured products it is the non-food items that have started to show an increase. There are two reasons for this phenomenon. The first is that the global prices for metals have started to increase on the back of an economic recovery in the western countries and continued acceleration in China. With the price correlation for all these products being high with domestic prices, the feedback into the system will only get more pronounced. Second, RBI has also pointed out that there has been an increase in capacity utilisation in several sectors, which means that demand is rising on both the consumption and investment fronts. Hence, it is not difficult to conjecture that this segment will continue to exert pressure on prices.
RBI’s move may also be interpreted as a further withdrawal of the stimulus that began with the Union Budget, which sought to reverse the tax concessions that were given earlier to keep the economy afloat. This is indicative of the fact that the government is really serious about being back on track and that the economy does not really require extraneous government support to continue growing, which is a good sign. In fact, the significant point here is that while the western governments have spoken of a phased withdrawal, ours is one of the first to actually do so. The only factor that could have averted this move would have been a fall in inflation, which has not been witnessed, despite the higher projected rabi crop this year.
While banks in the past have been equivocal in raising rates when RBI has announced increases in the repo/reverse repo rates, anecdotal evidence suggests that higher interest rates do not normally impinge on industry, especially when there is an upswing in activity, which appears to be the case today. Hence, it appears that there is no contradiction between growth and stability, notwithstanding the higher rates that may be charged by banks.
Liquidity will be under pressure, with both the private sector and government claiming bank resources against a withdrawal of liquidity through the enhanced CRR. Based on RBI’s projections of growth in deposits and credit, the banking system could finance around Rs 1.2 lakh crore of the borrowings of Rs 3.4 lakh crore. RBI would have to be active in the GSecs market with its open market operations (OMO) to provide liquidity when needed and also enable the borrowing programme in a non-obtrusive manner. The fact that foreign funds will continue to flow in provides comfort to the extent of increasing the available resources for lending. Last year, RBI used a combination of MSS bonds and OMO sales to support the government-borrowing programme. The former will not be available this year as RBI is pitching for mobilising these bonds to the extent of Rs 50,000 crore on the expectation of higher foreign inflows.
Interest rates would definitely not come down in such a situation, though banks will face a bigger challenge in aligning their base rate computations with the policy rates. Currently, all policy and deposit rates have moved into the negative real zone. Bond yields will tend to increase and the 10-year yield will remain above 8% during the first half of the year, when inflation continues to be high. RBI will have to persist with its noncommittal ideological approach to monetary policy—using a monetarist tool à la Friedman to tackle a Keynesian phenomenon of demand-pull inflation.