Column The big monetary squeeze

Written by Indranil Pan | Updated: Aug 3 2008, 02:50am hrs
Very few would have expected the bitter dose of another 50 bps of repo rate increase coming close on the heels of a 50 bps increase on June 24 and 25 bps hike on June 11. Most market participants had expected RBI to stay on a pause mode in this policy on the back of slowing growth, falling non-oil imports and some indications of steadying headline WPI inflation. However, in my opinion, RBI preferred a more forward looking stance to firmly anchor inflationary expectations, the clear priority for the central bank at the moment as opposed to pampering growth.

And RBI lays out its stand extremely clear. While most of the market participants would prefer to call the current high headline WPI inflation as supply side driven and caused by the sharp rise in the global prices of foodgrains, commodities and especially crude oil, the RBI thinks differently. It shows its leaning towards the monetarist school of thought by indicating that from 2005-06, the growth in money supply has been sustained at levels that were higher than its own indicative projections that have resulted in a sizeable monetary overhang in the system. This, RBI says, needs monitoring and the central bank aims to reduce the money supply growth to a range of around 17%, something it had anyway planned at the beginning of the financial year and what would also be consistent with the new GDP growth of 8% and an inflation target of 7% for end-March 2009.

Demand pressures are also evident in the widening trade deficit. Further, the very fact that the fiscal deficit is rising and fiscal policies are lax does only help in boosting the demand side argument to inflation. Admittedly, in an election year when the fiscal is burdened with payments towards the Sixth Pay commission awards and farm loan waiver, and is geared towards populist social sector expenditures, the onus of demand management squarely lies with the monetary policy.

To me, RBI is probably a bit optimistic on inflation when it assures the street that headline WPI inflation has likely almost peaked and is expected to move sideways from hereon till around Q3 before starting to come off. It is expected by RBI to come off sharply in Q4FY09 to end the FY at 7.0%. My calculations indicate that headline WPI inflation is still to see the peaks (expecting it to rise to around 13.5-14% and then at best come off to around 10% by end-March 2009) unless, of course, international crude oil prices and commodity prices come off very sharply.

Possibly for the first time we see some frustration from RBI in the sense that various rounds of tightening of monetary policy has failed to address the issue of reducing credit demand. As per the latest data available till the fortnight ending July 18, bank credit has increased by 25.8% y-o-y compared to 24.4% in the same period last year and is well above the central banks stated target of 20% for the current FY. With the SLR requirement being at 25% and with the CRR requirement 9%, the maximum incremental credit-deposit ratio could be at 66%. But it has been much higher than that recently as is indicated by RBI. A disaggregated picture of deployment of credit indicates that the growth in credit to the industrial sector has not moved any bit lower.

It was growing at 26.6% in June 06 and is now growing at 26.9% in May 08 and could be pointing some degree of failure of monetary policy transmission.

RBI uses moral suasion to address this issue. The central bank suggests that banks should focus on stricter credit appraisals, monitor loan to value ratios and ensure the health of credit portfolios without undertaking undue asset liability mismatches.

Overall, RBIs actions over the last month or so indicate an urgency to contain inflationary pressures. The current spate of adjustments is definitely not painless but could still be lower than what the system might encounter if RBI allows the ghost of inflation to worsen. In the latter case it can threaten the macro-economic stability and adjustments might then have to be sharper and more painful. With the average rate of inflation in this financial year already close to 10%, the real policy interest rate is still negative. This calls for more adjustments to the nominal rate and my sense is that RBI is unlikely to shy away from doing so. My bet is that RBI would like to increase the repo rate and CRR by 50 bps more in each case during this financial year and ensure achieving its goal of anchoring inflation expectations with financial stability and growth momentum.

The author is chief economist, Kotak Mahindra Bank. These are his personal views