How Raising CRR Is Part Of The Anti-inflationary Policy

Not unexpectedly, inflation continues to show no signs of abating. I think last week I had mentioned that for June 2004, the revised numbers show that inflation was on the average 0.86 percentage points higher than the provisional estimates. The revised data for the first week of July show the revised inflation figure at 0.92 percentage points higher. So, it is quite possible that while the provisional estimate of inflation for the week ending August 28, was 8.33%, the true or revised value might be over 9.2%.

The air is full of buzz about how the wholesale price index (WPI) data series has problems, how consumer prices still show low inflation, how we will soon have a new gizmo ? the producer price index. Surely, the WPI has its deficiencies, but it provides us with a powerful instrument that gives us a reasonable idea about movement in the prices of goods. Maybe if we had a better instrument for measuring inflation overnight, we might come up with a different number. But it would still be 7 or 8 or 9%, not a benign 3 or 4 or 5%. The WPI tells us unequivocally that inflation in goods is far too high for comfort and that it is getting worse.

The RBI on Saturday raised the cash reserve ratio (CRR) for banks from 4.5% to 5.0%, to be effected in two steps of 25 basis points each on September 18 and October 2, 2004. This is obviously a part of the RBI?s attempt to dampen inflationary pressures and alter the inflationary expectation. The conventional monetary response to inflation is, of course, to raise the policy rate. The impact of that travels up the yield curve and loans become costlier, which makes economic agents pause and think, and then re-assess how readily upward changes on the prices of what they sell? goods, services, fixed assets? would be absorbed by the market.

An increase in the policy interest rate is an outcome of a squeeze on money supply. So if you liked the old quantity theory of money, rather than new- fangled rational expectations, then with a lower stock on money supply, the money value of a given level of real output will be less than otherwise, that is, prices will tend to fall, or at least not rise further. Now, a change in the money value of goods and services is a change in the relative price of money and of goods and service. And what is the price of money? The rate of interest, of course. Which is why anti-inflationary measures for the RBI are all about the interest rate really.

What sense does one make of the RBI raising the CRR? Should it not have raised the policy rate, i.e, the repo rate? Last week, I tried to explain the problem of how the repo rate instead of acting as a floor had become an effective ceiling on overnight rates. That was because while over the past several years, reserve money had risen steeply, the repo rate or floor had been kept relatively high ? and at a level at which the market for overnight funds did not clear. The excess supply thus got parked in the repo facility and market rates (call money) started to hover just below the repo rate.

The RBI has been trying to suck out the excess liquidity, but clearly the rising inflation rate has added considerable urgency. By raising the CRR, it is my calculation that about Rs 7,500 crore would be taken out of the system. Clearly, the RBI hopes that were it to do so, it would help push the call money rates above the repo rate and allow the latter to truly act as a floor to the interest rate band, making monetary policy intervention easier and more effective, besides helping curb inflationary pressures. To make this work, however, bond prices have to be permitted to find their own genuine market-determined levels, the market stabilisation bond calendar may need some telescoping, and the repo rate needs to be raised. The sooner the better.

The writer is economic advisor, ICRA Ltd. The views are personal.