Last Friday, RBI raised short-term interest rates by 25 basis points. Most bankers reported that this will not impact lending rates. HDFC Bank dropped interest rates on home loans the same day. While this may be unrelated to RBI?s action, it is a reflection of the ineffectiveness of RBI?s action. But, this does not reduce the importance of this move. The base-rate announcements by banks have been lower than expected. Fears that the base-rate regime would raise lending rates were put to rest. Banks seem to be geared up in order to compete and gain market share in an economy that seems poised to accelerate growth. This growing demand and competition amongst banks is likely to keep interest rates low in the near future.

RBI had made its position clear when it squeezed out liquidity on April 24, 2010, by raising CRR from 5.75% to 6%. Deputy governor Subir Gokarn has stated clearly that the direction has been set in terms of an intervention to control inflation. The question thus has been how much and when, not whether.

The increase in interest rates well ahead of the scheduled policy announcement possibly indicates a gradual step-by-step raising of interest rates, rather than raising them significantly at once. This step-by-step approach may cushion the impact of a one-time significant hike in interest rates on the equity markets. It should be noted that the equity markets do not indicate any inflation in asset prices in the recent past. This is, possibly, another indicator that the inflation we see around now is not the result of excess liquidity causing excessive demand.

A sharp hike in interest rates may not bring down inflation, because inflation is driven by shortages and by bad measurement such as the way we measure inflation in rent. A hike in interest rates could be effective in controlling inflation even if inflation is driven by supply-side problems, if such a hike leads to a dampening of consumption demand. For this to happen, the hike in short-term interest rates should lead to a hike in lending that is sufficiently high to dissuade borrowers from accessing loans at the same rate as they have been in the past. But HDFC Bank?s announcement of a drop in its interest rates indicates that the dynamics of lending is driven by factors that are beyond RBI control. And, it would take a lot more on the part of RBI to actually rein in excessive demand.

But is there evidence of excessive demand? According to the Central Statistical Organisation, real private consumption expenditure had expanded by a meagre 4.3% in 2009-10. RBI statistics indicate that outstanding personal loans for consumer durables declined by 1.3% (YoY) and that for credit cards declined by 28.3%, while advances against fixed deposits grew only by 1.6% as of February 26, 2010. Housing loans grew by 9.1% and education loans by 31.2%. Overall personal consumer loans grew by a modest 4.7%.

While the most important lesson of the 2008 crisis is that leveraged consumption is dangerous and leverage beyond a point is calamitous, there is still some merit in increasing credit to households, if this can be done with responsibility. There is always also a genuine need for increasing personal loans.

Although there are no reliable official statistics to measure employment, it is very likely that employment in India is rising more than just modestly. The relentless growth in new capacities in the mining and manufacturing sectors is likely to have created substantial direct employment and also substantial indirect employment in support services such as trade and transport.

The increase in employment is bound to create new demand for credit. As young people settle into their new jobs, their need for housing and then consumer durable loans will rise. A lower and transparent interest rate regime will help in building confidence in this new class.

Wages have been rising, thanks to direct interventions by the government in employment (NREG) and also because of an increase in new job opportunities. Thus, the ability of households to service borrowings is also improving.

Banks must reach out to their potential new household customer. Perhaps, there is a need to build trust once again given that households have witnessed several financial upheavals in the past two years. It saw the global financial markets nearly collapse, local stock markets crash (although this impacted a minuscule proportion of the households); it saw serious questions being raised on the fees it paid to intermediaries for investments. Briefly it also feared job losses. Although most of this is behind us, the experience has brought in a degree of introspection.

Greater transparency and lower rates can help pull customers to banks. It is equally important that banks reach out to households in regions that are witnessing the greatest investments and therefore the greatest new jobs. A targeted effort will yield superior results.

Often, this phase of expansion soon turns boisterous?it brings in the infamous irrational exuberance. I see RBI?s action as a signal of caution and its posture to act further as a subtle threat against that irrational exuberance. Inflation will fall independently.

?The author heads the Centre for Monitoring Indian Economy