Don’t touch interest rates now: Financial Express: June 17, 2010

It is now a habit to over-react a month before a credit policy is announced. There is speculation about whether or not RBI will increase rates before July 27. This kind of hype is commonplace and while it should be ignored, it is serious business because often the revealed RBI response is to do so before the policy. Therefore, the markets may be right in a way.

If we look at the monetary situation today, it is quite interesting. There is a liquidity issue, as surplus funds deployed in reverse repo auctions towards the end of May have now changed to borrowing by banks from RBI through the repo route. Then, there was pressure on banks’ liquidity on account of higher borrowing by telecom companies. Therefore, RBI opened the window of allowing more borrowings by banks, which has been tantamount to an SLR reduction of 0.5%. Further, to ease pressure on banks, the size of the T-bills auctions has been reduced for June. As this is a temporary development, RBI did not opt for a CRR cut that would have induced around Rs 25,000 crore (based on a 50 bps reduction). Therefore, June is to be a month of RBI providing support to banks through liquidity easing measures.

Now we are concerned with inflation. But are the inflation numbers any different from what they were a month ago? The answer is no. A double-digit number is high but it doesn’t matter whether it is 10.16% or 11.04%, except if you are a statistician. Where is this inflation coming from? Primary products continue to display a number of above 15%, while fuel is also in the 13% region. Both these numbers have little to do with RBI. Food prices will remain high until the new harvest comes in and, even if it is good in October-December, prices may not fall sharply as the equilibrium has settled at a higher level. Anecdotal evidence suggests that prices do not revert to the ‘mean’ for commodity prices and instead create a new ‘mean’ at a higher level. Hence, if tur dal rose from, say, Rs 40 per kg to Rs 100 per kg last year, a good harvest may make it come down to Rs 60 per kg, but it would be unlikely that it would go back to the Rs 40 level. The same holds for sugar, pulses or edible oils.

Fuel prices are a function of the ministry of petroleum, and RBI cannot bring down prices by increasing rates. In fact, higher rates will push up the costs of petroleum companies, which can then argue for additional increase in the prices of their products. The government, probably keeping in mind high inflation, decided not to increase fuel prices, as a hike of, say, 10% in diesel and petrol has a direct inflationary impact of around 0.5%.

A closer look at the manufactured goods category reveals that the inflation rate for this category came down from a 7% range in January-March to 6.4% in May. This is the area that monetary policy can address. The heating up of this sector may be attributed to higher prices, which is also visible in the high IIP numbers. Food products and chemicals, with a combined weight of 23.5%, have shown a sharp declining trend. Metals, non-metallic minerals and textiles have witnessed a substantial increase in prices. Paper, rubber, leather products, transport equipment and machinery segments have displayed stable prices. Juxtaposing these numbers with the IIP growth numbers, the metals segment is the only one that has high growth in production and prices—a case of overheating. Here, too, the influence of global trend of increasing prices is distinct.

What does this mean for RBI? The central bank surely has to be concerned about the increase in prices of manufactured products, which broadly speaking is what core inflation is all about. There is definitely the possibility of pre-empting inflation, which is what monetary policy is all about, through interest rate intervention. However, there may not be justification for the monetary authority to intervene right now and increase rates. It could be reserved for the policy time when a clearer picture emerges on the monsoons.

RBI has indicated in its earlier policies that inflation would be the main variable to monitor. As stated earlier, the inflation numbers are high but do not carry an element of surprise today to warrant a response. Besides, it would also be odd that RBI should be supporting liquidity while hardening interest rates simultaneously. More importantly, RBI should ideally move away from surprises in its policy moves although, admittedly, hype and excessive discussions often do turn out to be self-fulfilling.