RBI tightens rates at Q1 2008-09 review of Monetary Policy

RBI in its first quarter review of monetary policy tightened interest rates. One can also see the press release for a quick preview. 

The policy actions are:

  • Repo rate increased by 50 bps to 9%.
  • Cash reserve ratio increased by 25 bps to 9.0% with effect from the fortnight beginning August 30, 2008
  • Reverse repo rate unchanged

The monetary  policy stance is pretty stern on inflation (hawkish in monetary policy lingo) and says:

The overall stance of monetary policy in 2008-09 will broadly continue to be:

  • To ensure a monetary and interest rate environment that accords high priority to price stability, well-anchored inflation expectations and orderly conditions in financial markets while being conducive to continuation of the growth momentum.
  • To respond swiftly on a continuing basis to the evolving constellation of adverse international developments and to the domestic situation impinging on inflation expectations, financial stability and growth momentum, with both conventional and unconventional measures, as appropriate.
  • To emphasise credit quality as well as credit delivery, in particular, for employment-intensive sectors, while pursuing financial inclusion.

Notice the term inflationary expectations being repeated. It has been mentioned 18 times in the report! Inflation expectations are extremely important (my report explains the importance of managing inflation expectations)

RBI has also revised its inflation forecasts for the year:

While the policy actions would aim to bring down the current intolerable level of inflation to a tolerable level of below 5.0 per cent as soon as possible and around 3.0 per cent over the medium-term, at this juncture a realistic policy endeavour would be to bring down inflation from the current level of about 11.0-12.0 per cent to a level close to 7.0 per cent by March 31, 2009.

This was important as inflation of 5% – 5.5% was simply not achievable. It is important to have flexibility in inflation targets. I have also noted that inflation targeting central banks though say these targets are flexible, have not revised their targets. End result, confusions.

RBI has also lowered its growth projections:

GDP growth projection for 2008-09 revised from the range of 8.0-8.5 per cent to around 8.0 per cent, barring domestic or external shocks.

I have been noticing numerous comments in media on their concern for falling growth.  True growth may have moderated/ may moderate but there is no choice between such high inflation and growth. Growth can still be brought on track, inflation if it goes out of hand can be really nasty. People interested in understanding issues with inflation may go through this St Louis Fed publication on inflation mess in 1970s.

Interestingly, given inflationary concerns markets were divided over rate hikes prior to policy. This article from Tamal Bandyopadhyay prior to mon policy was really amusing:

The market is divided on the stance of the July review, the last in the Reddy regime. Those bankers and bond dealers who strongly feel that the time is ripe to rein in Reddy’s aggression in raising rates, cite three developments to build their argument.
 
First, the drop in the wholesale price-based inflation from 11.91% to 11.89% for the week ended 12 July, the first such drop in two months.
 
Second, a decline in industrial production. The year-on-year growth rate in industrial production in May fell to 3.8%, its lowest in six years.
 
Finally, they point to a drop in crude oil prices.
 
I understand people have full right to make their own views but clearly something is wrong if people say RBI should not hike interest rates given the above three reasons. Inflation at 11.89% is anything but a decline (more on this here), IIP numbers need to be revised, and crude oil prices are extremely volatile and it is too early to say of the declining trend. For oil prices to decline, emerging markets need to slowdown quite a bit. Clearly, we can’t have both high growth and low inflation forever.
A central bank’s primary concern is inflation and it is nice to see RBI hiking rates more than market expectations. It has made its stance clear. It is serious about managing inflation.
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4 Responses to “RBI tightens rates at Q1 2008-09 review of Monetary Policy”

  1. Interest Rates » RBI tightens rates at Q1 2008-09 review of Monetary Policy Says:

    […] Read the rest of this great post here […]

  2. RBI tightens rates at Q1 2008-09 review of Monetary Policy Says:

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  3. Syed Zahid Ahamd Says:

    RBI is increasing inflation instead of controlling it!
    The action taken by RBI to control inflation is not admirable. The tool of interest is spoiling our nation. Every time attempt to control inflation through altering interest rate is easy for RBI, but disastrous for the economy. RBI should revisit the decisions taken up to control inflation. Interest can affect liquidity and control inflation for time being by curbing the demands but cannot control ultimate inflation as the higher deposits at banks will yield higher interest expended over those deposits which in turn enhance the purchasing power of the depositors with no increase in real GDP. Thus this practice by RBI to control inflation itself leads to inflation.
    The annual interest income by banks is over 5% of GDP at Market Prices. It means the prices of commodities and services produced with help of bank credits would be increased by at least 5%. Interest income by banks thus increases the price levels by minimum 5%. Moreover the interest expended by banks over deposits is over 3% of GDP at Market Prices. It means the deposits buying capacity would be increased due to interest while GDP remaining unaffected; the price level would further increase by at least 3%. So due to interest earned by banks and expended over deposits, the price level increases by over 8% per annum. In this situation if interest rate is further increased, the inflation will not be controlled, rather stagflation will increase. Already we can see that our total final consumption expenditure as % of GDP at market prices is declining from 67.8% in 2005-06 to 65.5% by 2007-08. This decline along with inflation cannot be controlled by increase in interest rate. On the contrary, we need stimulator for productivity and sales in the real market, which requires reduction in interest rate.
    The practice of RBI to control inflation by interest rate is disastrous for Indian economy and should be questioned. The role of interest to control liquidity is not questionable but its impact over income level of depositors, borrowers and the price level should be re-considered and it is important that RBI should review these impacts. It should be noted that if banks expend worth 3% of GDP at market prices as interest to deposits, the liquidity automatically increases without real change in GDP, thus causing inflation.
    We should consider and find long term solution for instability in financial and real markets. If RBI or financial sector regulators wish, Islamic ethics on Banking and Finance may guide us promote ant inflationary, stable and equitable system for economic growth. Islamic Banking is the most needed mechanism at this time which could solve the problems. The fear that Islamic banking would not benefit the corporate or nationalized bankers is just based on prejudice only. The corporate and national bankers along with stock market would be in better position after introduction of Islamic Banking. Islamic Banking would also increase D mat account and capitalization at stock market. Hopefully AMU with attempt to promote education about Islamic Banking and Finance may improve our understanding about the alternative banking and financial mechanism. Islam advocates for anti inflationary and stable economic system with socio-economic justice as an objective of governance.
    Syed Zahid Ahmad

  4. Syed Zahid Ahmad Says:

    We need Economists to Manage the Economic Affairs

    It is better to see Dr. C. Rangarajan Resigned form as Chief of EAC for the Prime Minister. He might be eying a bright career as consultant for new growing business of financial inclusion. This way he might also escaped from facing the utter failure of UPA government in economic front with comprising two great economists. Rangarajan in his tenure might have delivered many advices but for last 24 months his advices were not resulting positively. RBI with increasing CRR and Repo rate since July 2006 is helping inflation to grow more on the name of taming inflation. These experts from financial sector hardly evaluate multi tier effects of interest in our economic process. We sincerely need economists who could well design policies for growth of financial sector as well as other segments of the society with prices under control. This is all we meant for real foster inclusive growth – the slogan of our 11th five year plan. Since Rangarajan was not going according to plan, he should have better resigned earlier.

    I don’t know what is happening. Our Finance Minister might be bit confused. At one side he says supplies will be increased on the other he supports tight monetary policy by RBI which means for costlier credit supply. The Finance Minster may be asked about how he expects that costly credits are going to help us increasing the supply and reducing the prices. The new produces with costlier credits will certainly add value of credit costs into cost of output. With costly credit fewer will opt to have credit to extend supply capacity. So let our finance minister and RBI explain us that how costly credit is going to increase the supply or minimizing the cost and price of GDP.

    What should have been done in fact is to frame a planned policy to allocate FDI to desired segments which has actually increased liquidity in some selected segments which is causing problems for us. So instead of making the credit costly, the regulators should make planned policy to allocate liquidity to desired segments instead of automated. Off course for this they need to do better home work as compared to deliver political statements and press conferences before the media.

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