RBI should hold on to current interest rates

October 25, 2010

(D. H. Pai Panandiker is President of RPG Foundation. The views expressed in this column are his own and do not represent those of Reuters)

By D. H. Pai Panandiker

To raise or not to raise the repo rate is the question. For one, inflation continues to be high; for another, growth may tumble.

The present inflationary spiral began in December 2009 when the WPI crossed 5 percent. The first rate intervention by the RBI came in February when the repo rate was raised 25 bps. Since then it has jumped four times without any reversal of inflation spiral.

Not that our experience is unique. In fact, the experience of most countries that have confronted inflation has been similar. That is because the impact of interest hike, except on financial assets, is uncertain and takes time to make a difference to demand and consequently prices.

First, the repo rate is addressed to the banks; it is the interest on bank credit that matters to the public. It is not necessary that the commercial banks instantly react to the increased repo rate. If they are saddled with excess liquidity, they will take time before they put up their own rates of interest.

Besides, the RBI raised the repo rates by baby steps of 25 bps each time. This does not create the shock effect that can curb consumption or investment.

Second, there is time lag between the increase in interest on credit and the fall in demand for consumer and producer goods. Since, in India, most consumer goods are not purchased on credit, like for instance, food articles which are a major constituent of consumption, their prices are absolutely unrelated to the interest rates. No wonder, in spite of the increase in repo rate, food inflation is still over 15 percent.

The more sensitive products that are impacted by the interest rates are automobiles and homes, both of which are generally purchased on credit. Since repayment is spread over a longer time the interest burden becomes heavy. The depth of impact also depends on the expectations of the consumers. If prices are expected to rise in future, it would still be attractive for them to borrow at a higher rate.

The demand for producer goods can be significantly influenced by the cost of borrowing. Trade and industry will reduce inventories when interest rate rises because the cost of holding stocks increases. The reduction of inventories reduces demand and can prompt industry to cut production but not prices. That is because an increase in interest rate shaves off profit margins which are a strategic business target. Consequently, industry will raise prices to make up the margins.

It is no surprise therefore that, with the increase in repo rate by 150 bps in the last eight months, there has been no impact on food prices and an actual increase in prices in the non-food sector.

If experience is any guide, the best option for the RBI is to hold on to the current rates of interest rather than go in for another round of rate hikes.

(You can e-mail Dinker H. Pai Panandiker at: dpanandiker@gmail.com)

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This is only one side of story.The issue has to be looked in totality considering other circumstances &fully disagree with the views.RBI must continue increasing rates to curb this menace.These baby steps are atleast not hampering the macroeconomics.

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