RBI hike expected, but will it tame inflation?

The RBI has increased the interest rates to tame inflation. But is it enough?

Anil Kumar Satapathy

Once again, the Reserve Bank of India (RBI) has chartered the rule-book way to tame inflation, but very cautiously. On Tuesday, the RBI raised its key lending and borrowing rates as well as the cash reserve ratio (CRR) by 25 basis points (0.25 percent) each. This is the second time in as many months that the central bank has raised rates to choke out money from the markets as inflation is rising as a potential threat to India’s economic recovery. The central bank lifted the reverse repo rate, at which it absorbs excess cash from the banking system, by 25 basis points to 3.75 percent. It increased the repo rate, at which it lends to banks, by 25 basis points to 5.25 percent. Further, it raised the reserve requirement for banks by 25 basis points to 6.00 percent. According to estimates, the hike in CRR will suck out Rs 12,500 crore from the banking system. The CRR increase will come into effect from April 24. "With the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalising our policy instruments," RBI Governor Duvvuri Subbarao said in the policy statement. Interestingly, India last month became the second G-20 economy after Australia, to raise policy interest rates as the world economy recovers from the worst downturn in decades. The central bank last month surprised markets by raising rates by 25 basis points. Malaysia and China too have begun to use monetary tools to cool their economies. Is it sufficient? Though many had foreseen a hike in interest rate, Tuesday’s hike was less than expected. As inflation was continuously rising and food prices were ruling high, many economists predicted that the RBI would go for harsher decisions. A 50 basis point hike in interest rates and a 75 basis point in CRR was their expectation. However, D Subbarao chose the middle path in full conviction that a marginal hike would not derail the economic growth. If inflation is not cooling off, the central bank would not wait for the next quarterly policy review to further tighten the monetary policy. This less-than-expected hike has actually restored the confidence of investors in equities. Markets, which are on a losing spree for the last few days, returned to green Tuesday, thanks to the RBI’s cautious move and Asian cues. The BSE sensitive index, Sensex, closed around 60 points higher Tuesday. However, not everybody welcomes the rate hike decision. “Basically, their statement and tone is hawkish,” Ramya Suryanarayanan, an economist at DBS Bank in Singapore, said. For the critics, inflation is a result of supply-side bottlenecks and money tightening would not bring the prices down, but endanger the fragile economic recovery. The low interest rate regime in the US will still facilitate cheap money abroad which can be trashed here in India due to high interest rates – putting pressure on the rupee, they say. Also all eyes are now on the Rabi crop. A good crop will soften food prices, which would give RBI an opportunity to keep rates low. “The move is smaller than expected. That suggests that another 25 basis point hike is highly likely this quarter. We expect the repo rate going up to 6.25 percent by end December,” Ramya Suryanarayanan, economist at DBS bank in Singapore, told a financial daily. In a similar view, Vishnu Varathan, economist at Forecast in Singapore, said the RBI could again hike rates by another 50-75 bps before June-end. People like, ICICI Securities’ A Prasanna predicted the reverse repo rate at 4.75 percent and repo rate at 6.25 percent by March 2011. Planning Commission Deputy Chairperson Montek Singh Ahluwalia has made it clear. If inflation eases there won’t be any further immediate rate hike. The undertone is that, the RBI would use the monetary tools again if inflation is not cooling down. Moreover, if the government thinks it can manage inflation only by forcing the RBI to use the monetary tools, there is no doubt that it will hit a road block soon. The policy rates cannot be raised beyond certain level as it would squeeze the credit flow and dry up demand. Therefore the government should take a serious view of the situation and immediately adopt measures to remove the supply side bottlenecks and hoarding. Only a combined administrative and monetary initiative could tame inflation. The RBI has done its bit. What about the government?