The end of repo rate hike?

October 29, 2011

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

Apparently, the RBI is exasperated. After 18 months of inflation and 13 hikes in repo rate, RBI Governor Duvvuri Subbarao more or less admitted a day before Diwali that the pursuit of interest policy had gone far enough even though it hardly made any different to inflation and only deflated the growth rate instead. But he is not without hope.

The RBI believes that inflation will begin to decline from December, reach 7 percent by March and ease further in the first half of 2012-13. What has made the RBI indulge in these amusing predictions is not convincingly explained. Having been accused of pulling down growth, the RBI also expects that investment will pick up once inflation is pushed down, suggesting that a reversal of monetary policy will follow.

Undoubtedly, the RBI, like other central banks, is charged with the responsibility of maintaining price stability. For the RBI, inflation is the principal target of policy and interest rate the most preferred weapon. Three years ago in July 2008, India had inflation exceeding 11 percent and the RBI had kicked up the repo rate to 9 percent. In just three months, inflation took a plunge — not so much in response to the interest hike as from the impact of the world financial crisis in September of that year.

Besides, the inflation of 2008 was intrinsically different from the inflation of 2011. The earlier inflation originated in the industrial sector and did necessitate an interest hike to cool it down. The present inflation is largely due to supply deficit of select agricultural commodities. The RBI was fully aware that the present inflation required government intervention much more than its own. But the government wholly relied on the RBI.

The supply deficit is in respect of protein-rich foods like milk, pulses, fruits and vegetables, and meat and eggs. That reflects an ongoing change in people’s consumption pattern, from carbohydrates to proteins, induced mainly by improvement in incomes. No wonder per capita consumption of cereals has been static in the past 5 years. What is critical is that the demand-supply gap in these protein-rich foods has not narrowed and the RBI may not be quite right in presuming that inflation will decline from December and taper down in the first half of the next year.

Indications are that food inflation has become almost chronic. Even though supply is increasing, demand for select foods is increasing even faster, preventing inflation from easing. The repo rate can hardly make any difference to that demand. But supply can be increased much more if governments extend facilities to farmers like interest subsidy, improved seeds, etc. and create an environment for efficient marketing and reduction in distribution cost.

The suggested pause in interest hike by the RBI was necessary a long time back. That would have prevented the fall in industrial growth which also pulled down GDP growth. But if food inflation refuses to relent, the RBI, going by habit, may increase the interest rate even after the December review.

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