A few weeks ago, RBI raised the cash reserve ratio. To many analysts, the recent rise in inflation has more to do with supply factors such as the increase in world oil and metal prices, rather than monetary issues. But looking at the medicine, it would appear that the RBI believes that the rise in prices is demand-driven. Since inflation has not been fully reined in to the extent that the government would wish it to be, we could expect more of the same medicine. The argument in favour of raising interest rates is that monetary policy was expansionary in the last couple of years owing to the massive buildup of foreign currency reserves. The ratio of money supply (M3) to GDP has risen. To undo this rise, money supply must be tightened.
But raising rates also involves difficulties. A hike in rates may put the incipient investment recovery in danger. In fact, in 1996 an almost identical situation had occurred. The RBI had res-ponded to the inflow of foreign capital in 1994-95 by massive intervention in the foreign exchange market to prevent the rupee from appreciating. This had led to a sharp rise in money supply and an increase in the inflation rate. The RBI responded by raising interest rates through various direct and indirect measures. The result was a sharp rise in borrowing rates, and a steep decline in investment and industrial growth. While the decline in investment may have taken place in any case due to various other factors, the suddenness and sharpness of the decline can be attributed to the sharp rise in the cost of capital.
If RBI wants to raise repo rates, it should prepare the country for it
Monetary policy formulation must be made more transparent
Another element to consider is that Bimal Jalan successfully made the credit policy a non-event. Before that, interest rates would be changed with credit policy announcements. Dr Jalan created a more modern framework for monetary policy in which changes in interest rates were made according to the requirements of the economy, rather than on pre-specified dates.
Is Dr Reddy going to undo this progress and announce changes in interest rates on the day of the credit policy
If he does it would be imprudent to do so. RBI can learn a lot from Alan Greenspan who, when he felt that inflation in the US was rising, shared his views with the country.
For many months, in several speeches, he said that he would raise interest rates. For months observers watched and waited, hanging on to every word uttered by Greenspan. The question became when and not if. The economy was well prepared for the fed rate hike when it came.
If RBI believes that inflation has to be addressed by tight money policy, and they are going to raise the repo rate, they should prepare the country for it. Households taking floating home loans should know what to expect. Firms making investment decisions would be able to factor in these aspects. Expectations need to be well in place before making policy changes. What Dr Reddy needs to do tomorrow is not to raise rates, but to explain his views on the causes of inflation and what people should expect on interest rates.The mid-year review should be a time for the country to learn his views rather than to speculate about changes in rates. Dr Reddy should work on making the monetary policy process transparent and open.