In my column last week, I looked back on the key drivers of RBI?s monetary policy stance during the previous episode of tightening since 2005-06, in the context of the three major decision variables?timing, choice of instruments and extent?that were observed and the outcome of that particular sequence of tightening. I stated that the initial period of gradual tightening of repo and reverse repo rates in 2005 and 2006 had probably been relatively ineffective, and only an augmentation through CRR increases and then a rapid intense burst of policy interest rates led to a cooling off of key outcome expectations.
There are indications that RBI is also thinking along these lines. A relatively steep phased 75-basis-point increase in the CRR, phased through February, preceded the repo rate increase in mid-March. How is this tightening likely to play out through 2010? The first issue is clearly the determination of a neutral policy rate that balances ?potential? output and inflation. Determination of a so-called non-accelerating rate of unemployment (output) is probably more suited for mature economies and remains analytically and statistically challenging for a fast-growing economy, with higher non-stationarity and volatility. As a substitute and highly imperfect rule of thumb, we assume that real rates of interest (presumably at the shorter end of the yield curve) have to be 2-2.5 percentage points above the anticipated inflation. Why? Only because developed country analytics suggest some such mark-up. Considering that average WPI inflation, a very imperfect indicator of price pressures, will probably be around 6% over the next couple of years, interest rates should move towards 8.5%, phased over the next two years.
If this looks to be too high a rate for a short-term policy rate, which would probably push up cost of funds to borrowers to levels that would make much of investments commercially unviable, an alternative might be RBI?s inflation target. As late as the third quarter policy review, RBI remained emphatic that monetary policy would ?condition and contain perception of inflation (at) 4-4.5%.?
Which interest rates and how much should they rise? The monetary transmission mechanism for policy signals in India presumably relies mainly on banks? cost of borrowed funds. The average tenor of these funds is less than a year. A publicly available, if imperfect, proxy for these costs, therefore, is the 364-day T-bills yield, a relatively liquid instrument. During presumably more normal years, prior to the onset of the financial turbulence, these rates have been about 94 to 110 basis points (bps) above the reverse repo rate. Of course, bank?s short-term funds would involve credit risk mark-ups; an AA 2-year paper?s spread has been about 130 bps. A reverse repo rise from the current 3.5% to 4.5% should, with a bit of luck, push the cost of short-term bank funds up to 6.7%.
As liquidity begins to shrink, the short end of the yield curve should also begin to move towards the higher end of the liquidity adjustment facility (LAF) corridor, pushing rates towards the policy target. In addition, regulatory changes on banks? savings deposit rate calculations and the impending transition to the Base rate from the erstwhile benchmark PLR will impart a hardening bias to borrowers? cost of funds. All of this indicates a range of 6-6.5% as ?fair value? for the LAF repo rate, currently at 5%.
This brings us to the issue of liquidity. After dropping to less than Rs 500 crore in end-March, due inter alia to year-end requirements, LAF liquidity has come back almost up to Rs 1,20,000 crore. Although this will gradually constrict over time, banks have an alternative pool to tap into: Rs 1,00,000 crore parked in mutual funds. Given the anticipated rising cost of bank funds, some corporate credit demand is bound to ricochet back towards mutual funds. RBI has already expressed its apprehension about the use of mutual funds as an unregulated shadow banking channels; it will try to get these funds back into banks. If this draining from mutual funds increases costs of corporate commercial papers by a couple of percentage points, well, that just reinforces the policy signals.
So what does this portend for RBI?s tightening stance? The arguments in the two parts would indicate a combination of a repo/reverse repo increase together with a CRR increase. The latter would probably precede the rate hikes on April 20, probably as early as today. Given current forecast trajectories of key variables, a 50 bps repo increase, a pause thereafter for a few months and then a graded series of 25 bps might be an effective sequencing, pushing up the repo rate to 6.5% over next 18 months.
The author is vice-president, business and economic research, Axis Bank. Views are personal