Is another hike in repo rate necessary?

March 15, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

A man talks on his mobile phone as he walks past the logo of the Reserve Bank of India (RBI) inside its head office in Mumbai June 14, 2010. REUTERS/Rupak De Chowdhuri/FilesOn March 17, the RBI will review the quarterly performance of the economy and readjust the repo rate. In the past one year the rate was jacked up seven times at 25 bps on each occasion from 4.75 to 6.5 percent. The target was inflation.

Obviously, even after 12 months inflation remained untouched by the repo rate though it created other expected but undesirable side effects.

There were two reasons why the attempt did not succeed. First, inflation was not caused by overheating of the economy and therefore could not respond to monetary policy. It originated in the agricultural sector. The worst hit were vegetables, fruits and meat. In the manufacturing sector inflation was mild and was caused mainly by the spread effect of inflation in the agricultural sector and higher international prices of industrial raw materials.

Second, the baby steps of 25 bps at a time did not create the shock effect that is necessary to curb demand. If the 175 bps increase had been made in a single sweep, perhaps the result, as far as inflation is concerned, would have been significant. However that would have caused serious dislocation which would have hit growth badly. For that reason, most central banks prefer to increase interest rates in small doses so that adjustments become easy.

The situation now seems to have significantly changed. Food inflation which had shot up to 18 percent in December has slowed down to single digits and may be back to normal in another month or so, pulling down headline inflation with it. Therefore further hikes in repo are not necessary particularly because the adverse side effects of higher interest rate are gathering momentum.

It is true that the repo rate is not the only reason for increase in interest rates across the board. There has been liquidity shortage. Credit has outpaced deposits. Further, the auctioning of 3G spectrum and divestment in public sector enterprises transferred 850 billion rupees to the RBI, though government borrowing  became less aggressive.

The increase in interest rates is having its bite. Interest payment is a small part of the cost of production in industry. But it is more than 15 percent of gross profits of companies, on  average. The rise in interest rate has reduced the profits available for dividends or retained to fund further investment. The margin between interest and profits which really drives investment has been squeezed.

It is no wonder that much of the investment has been on hold and the capital goods industry had to cut production drastically. In the two months, December and January, production was down 9 percent and 18 percent respectively. That will hit growth if the cut is continued further.

The repo rate has made no difference to food inflation which has decelerated for other reasons. But its adverse side effects are already becoming visible. The best option for the RBI now is to pause and reverse the rates once inflation is down to 5 percent.

POLL – RBI rate hike expectations increase for 2011

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