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Why the RBI raised interest rates

January 29, 2014

(Any opinions expressed here are those of the author and not of Thomson Reuters)

The Reserve Bank of India (RBI) raised interest rates at its review on Jan 28. The justification usually given for doing so is inflation.

But at its previous review, when inflation had soared, the RBI was passive and left rates unchanged. Now, with wholesale price inflation (WPI) slowing to 6.16 percent, the RBI was quick to raise the repo rate by 25 bps back to its highest level since the 2008 crisis. Why?

Targeting inflation is surely not the sole object of monetary policy. There have been other considerations, though price stability had precedence. The RBI has recognized the need but did not sufficiently facilitate growth in industry and services. That had been the bone of contention between the RBI and the finance ministry.

The RBI maintained that interest rates alone cannot revive growth because it was suppressed by other obstructive factors, mainly delays in government decisions.

Whatever the reasons, growth in industry never picked up, creating a strange contrast between trends in the two important sectors of the economy. The agricultural sector is generating inflation largely restricted to the food basket; the manufacturing sector is slipping into recession and job losses.

Though focused on inflation, the repo rate hike has been unable to stop or reduce it and has, to an extent, helped only to accelerate recession in industry. The economy has been left hanging between these two poles.

In the meantime, a third outcome has emerged. The rupee came under pressure because, with high domestic inflation, the external value of the currency dropped. In August, the rupee dipped to near 69 to the dollar, though corrected for inflation, it should have been at 60-61 to the dollar.

Rupee stability became and continues to be the major challenge for the RBI and, in spite of exigencies, it has been able to build up foreign exchange reserves, principally from external borrowing. The rupee has consequently developed some muscle, although not strong enough to withstand additional external pressures. Other supporting measures were necessary.

It was against this background that the RBI went in for a rate hike. One reason may be the shift in reference point for inflation, which will now be the consumer price index instead of wholesale price inflation.

The second, though not explicitly expressed, is the need to strengthen the rupee against QE tapering. With the current account deficit at 2.5 percent (down from 4.8 percent) and elevated rates, external borrowing will become more competitive, making the rupee less vulnerable. However, continued food inflation can soon weaken the rupee and render a further reserve build-up more difficult.

Raising the repo rate can help but has obvious limitations, which if exceeded, would have a devastating effect. This is what makes the RBI focus on the urgent need to control CPI inflation, even for supporting the rupee.

Full coverage of the RBI policy review

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