Was the repo rate hike necessary?

September 21, 2013

The decision of the U.S. Federal Reserve to delay tapering its bond purchases cheered markets, and more so in India because they were convinced of a second bonanza from the RBI. But new Governor Raghuram Rajan gave the markets a jolt by turning hawkish and increasing the repo rate.

The gains of the previous day following the Fed meeting were nearly wiped out and the rupee, which was steadily crawling towards 60 to the dollar, also fell back. The only reason why the RBI increased the repo rate was the revival of inflation, which had dropped to less than 5 percent in April-June.

That trend was reversed in July and accelerated in August when the WPI climbed to a six-month high.  That must have led the governor to turn cautious.

It is true that interest rate as a matter of policy has to be higher than the rate of inflation. In other words the real rate of interest (inflation rate minus interest rate, repo in this case) has to be positive. In the past 20 months, real repo rate has been positive except in two months – August and September 2012 – when inflation was over 8 percent.

In 2012, the average rate of inflation was 7.5 percent. Even so, the RBI actually cut the repo rate in one big sweep from 8.5 percent to 8 percent. The average real repo rate in 2012 was 0.58 percent. Since March this year, inflation slowed down and the repo rate was reduced in three baby steps from 8 percent to 7.25 percent. Consequently, the real repo rate climbed up to nearly 3 percent in April. With inflation up at 6.1 percent, the real repo rate will now be about 1 percent.

Repo is not the rate that should bother bank borrowers except to the extent that it can affect the base rate at which banks lend. Earlier in September, the base rate of banks was 2.45-3 percent above the repo rate.

Two conclusions follow. Firstly, the increase in the repo rate was not really necessary since it was well above the inflation rate, the difference being twice what it was in 2012. Secondly, there is enough elbow room for banks to absorb the additional costs following the increase in repo rate. It is more likely that banks will not increase lending rates, which makes market response a little exaggerated.

What is important now is the long-term policy of the RBI, which has to innovate to revive growth by encouraging investment cycle and reducing current account deficit to stabilize the rupee.

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Probably someone who understands inflation better than any governor, will wait and watch. Fingures crossed, we may be on the right path – it’s not fun for the ageing population to lose their spending power and inflation eats away the real gdp growth. Growth needs to be sustainable and inclusive, and raising the interest rate would be the right thing to do to contain inflation, contain asset price bubble – how many average workers in Mumbai can actually afford a flat (I am talking about the down payment here, one could argue lower interest rate increases affordability – I argue it only helps increase the bubble, an increase in rate (in the current environment) would ultimately help all who make a genuine living.

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