The ?surprise? rate hike by RBI mid-March has led to intense speculation about the next steps in the tightening sequence. Second-guessing RBI is a daunting task, but here goes. To get meaningful insight into the decision-making process, a combination of forward-looking trends and a look back at the environment during the last tightening cycle is likely to produce the best results. The objective is clearly a balance between maintaining growth impulses, containing current inflation impulses, anchoring inflation expectations and managing liquidity to facilitate the expected increase in bank credit and an orderly conduct of the government?s market borrowing programme. Managing the yield curve would be a secondary objective of financial stability, since an unwarranted tightening is likely to have adverse effects on banks? balance sheets through an increase in bad assets and consequences on their capital reserves. The rest of the process comprises creating or deepening appropriate markets to strengthen the policy transmission mechanism.
Given these objectives, there are three dimensions to the policymaking process: (a) timing of the increase, (b) choice of instruments and (c) extent of tightening. Each dimension will have associated economic and financial variables, mostly interacting and overlapping. We will explore these instrumentalities and their presumed trajectory in a historical context in a follow-up column. The predominant decision variable at present has to be inflation. WPI inflation is almost sure to have crossed into double digits in March, widely anticipated by markets and by many policy authorities, and very likely to start moderating thereafter. This fall is mainly a statistical artifact due to the base effect of the pace of increase over the previous eight months.
This leads to the first issue of timing. If inflation is the primary target, how justifiable can a sequence of rate rises be once inflation starts moderating? RBI?s medium-term inflation target of 3%, one it perceives to be consistent with sustainable growth, can then be used as an argument for continued tightening even during the descent phase. Whether this inflation level can be justified as consistent with a high growth ecosystem is open to debate; during the last decade, WPI inflation moved in a tight band around a trend level of 6%. What is certainly remarkable in a visual track of inflation is the increasing amplitude of oscillations in all the components?primary, fuels and manufacturing. This will definitely need to be damped down. Quite apart from the effects in fostering a wage price spiral, this volatility is inimical to the development of bond markets and of policy calibration.
To evaluate the issues of instrumentalities and magnitude of tightening, it might be worthwhile at this juncture to revisit the prevailing environment during the previous tightening cycle. Over 2004 to 2007, RBI increased the repo rate by 175 basis points (bps) and reverse repo by 150 bps and then held it there for a year before increasing it 125 bps in mid-2008. The reverse repo tightening preceded the repo increase, with the obvious intent of compressing the liquidity adjustment facility (LAF) corridor and moving the call rate higher. Midway through the first series of repo rate increases, at end-2006, it started increasing the cash reserve ratio (CRR), increasing it a full 400 bps till mid-2008, just before the onset of the Lehman crisis.
The effects of the repo rate increases were decidedly mixed. Industrial growth kept increasing right up to March 2007, and there was little perceptible trend change in inflation end-2007, after which time the presumed speculative commodities positions, global liquidity fuelled, surged to the July 2008 peak. The only variable that seemed to have responded to early tightening was bank credit, with incremental growth rates levelling off at mid-30% levels, before tightening policy traction pulled it down to the mid-20s. Even this moderation might have been due more to a move of credit demand away from banks towards alternative sources, both domestic and global, leveraging on differentials in the cost of respective funds.
Two possible inferences relevant for the current environment can be drawn. One, given the relative ineffectiveness of the phased and gradual increase in policy rates in the early period of the previous episode, a much sharper trajectory of rate rises, more intense even if short-lived, might provide traction for policy to moderate economic activity. This is likely to be an erroneous inference since the current global environment is a meek shadow of its former self and is likely to inflict severe damage to economic growth. The second possible inference is the use of liquidity control as the preceding, if not the primary, tool of policy tightening, implemented prior to, and/or in conjunction with, policy interest rates. A look at LAF liquidity charts in 2007 shows a massive CRR-driven constriction of banking liquidity, coterminous with the deceleration in activity. This was at the acme of the global boom, with enormous capital flows and heightened MSS activity.
The author is senior vice-president, business and economic research, Axis Bank. These are his personal views