India’s RBI hikes rate to curb inflation. It will have to try harder

On Tuesday, India’s central bank unveiled its its second-quarter review of monetary policy for 2013-2014. Judging by the contents, it’s clear that governor Dr Raghuram G. Rajan clearly has one thing on his mind: clamping down on the economy’s persistent inflation.

It’s a task he inherits from predecessor Dr Duvvuri Subbarao, who spent almost all his time in office struggling to tame flaring prices even as the government stood by doing pretty much nothing to push for badly needed economic reforms to encourage investment. In fact, it added to inflationary pressures by embarking on spending binges.  Dr Rajan, a high profile ex-International Monetary Fund staffer who joined the Reserve Bank of India in September this year, will have to get used to such pesky hindrances to monetary policy making.

Here’s a quick run-down of the main highlights of the RBI’s policy review:

1) The repo rate was hiked by 25 basis points to 7.75%. (One hundred basis points make one percentage point.)The repo rate, at which the central bank lends to commercial banks for the short term, is the effective policy rate, which means that it is the rate that affects lending in the financial system.

A hike in the repo rate (the second in as many months) raises interest rates in the broader economy and curbs demand and prices, shows that Rajan’s RBI, just like Subbarao’s RBI, is taking a hard stance against inflation. “WPI inflation is expected to remain higher than current levels through most of the remaining part of the year, warranting an appropriate policy response,” Rajan said in his review statements. “Retail inflation is likely to remain around or even above 9% in the months ahead, absent policy action.”

India’s wholesale price index, a widely tracked measure of inflation, rose 6.46% in September from a year ago, higher than expected. The consumer price index, a measure of retail inflation, also jumped to 9.84%, compared with 9.52% the previous month.  Food prices have been a major contributor to high prices. In particular, onion prices have quadrupled in the past three months, and now cost over Rs 100 rupees a kilo.

2) Repo limits have been increased to 0.5 % of net demand and time liabilities of the banking system from 0.25%.

Simply put, banks can borrow more through repo transactions. Net demand and time liabilities refer to savings, current deposits and fixed deposits parked in the banking system. Banks could borrow a total of 0.25% of the value of those deposits earlier, that limit has been expanded to 0.5% of deposits.

The move is aimed at helping banks cope with demand for additional funds during the current festive season because of the typical higher credit demand. It’s a move aimed at improving liquidity in the financial system.

3) The marginal standing facility rate was lowered by 25 basis points to 8.75%.

MSF was introduced as an emergency borrowing facility for banks. When the rupee plunged to fresh lows in July-August over concerns about the country’s widening current account deficit and potential investor pull-out if the U.S. Federal Reserve went ahead with its ‘tapering’ (withdrawal of monetary stimulus) plan, the central bank lifted the MSF facility rate by 200 basis points to curb speculation.

It rolled back 75 basis points of that at its 20 September review and another 50 basis points earlier this month. These changes restore the gap between the repo rate and MSF to the usual 100 basis points, reversing steps taken to curb liquidity and speculation on the rupee. Again, that is a step to inject additional liquidity to the financial system.

4) The estimate for India’s annual GDP growth (April-March) for 2012-2013 has been revised to 5%. The revival of large stalled projects, clearances of investment proposals by the government, improving exports and agricultural sector performance are expected to buoy growth in the second half of the financial year. Real growth in the first quarter (April-June) came in at 4.4%.

Overall, the policy review has focused on curbing inflation, while injecting sufficient liquidity into the system. However, given the government’s resistance to lend a helping hand in the form of appropriate fiscal prudence and reforms to ease supply bottlenecks, there is only so much the RBI can do. Monetary policy alone cannot drive (or kill) growth  or inflation in an economy, especially when accompanied by government policies that determined to fuel inflation.  But for now, the RBI is the sole firefighter trying to douse the flames of inflation. It will be a hard battle to win.

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One thought on “India’s RBI hikes rate to curb inflation. It will have to try harder

  1. Pingback: Happy Diwali! India’s Sensex soars to record high | Wall of Money

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