Repo rate likely to increase to 7.5%

Written by Indranil Pan | Updated: Jan 26 2011, 07:42am hrs
This was probably one of the most debated policies of the recent times, especially as it comes after a phase when RBI was perceived to have paused. To put the debate in perspective, Headline WPI inflation surprised all on the higher side in December and hence most market agents expected RBI to hike policy rates by 50 bps. However, the RBI increased Repo and Reverse Repo rates by only 25 bps.

No doubt, containing inflation comes out as priority for the monetary policy. And most interestingly, the RBI has increased its inflation projection significantly higher to around 7%, from the earlier expected levels of 5.5%. The growth target has been maintained at 8.5% but even with the new growth-inflation dynamics, RBI has preferred to stay cautious and calibrated while moving on the policy rates. This takes us to a more basic understanding of macro dynamics in India where the onus of containing inflation simply falls squarely on RBI, when the going on this particular macro variable gets tough. Former RBI governor YV Reddy had used the sledge hammer measure, increasing the CRR to its peak of 9% and the Repo Rate to 9%, when inflation had moved into double digits in the early part of FY09.

The monetary policy document released on Tuesday and also the macro-economic statement released on Monday indicates that RBI could be fighting a lone battle on inflation. RBI on its own is unlikely to win this battle as monetary policy is rendered ineffective in addressing supply side-price shocks, which have been at the root of the current bout of domestic inflation. The uptrend in domestic inflation is largely a result of structural imbalances in several protein-rich food items such as milk, eggs, meat, etc. Moreover, transitory supply shocks such as recently witnessed with respect to vegetables prices and fuel price increases have further added to the inflationary pressures. There is an urgent need for action to increase the output of a number of products, the demand for which is being driven by changing consumption patters, points out RBI.

The interesting fact is that in this policy document, RBI stresses: monetary policy works most efficiently while dealing with an inflationary situation when the fiscal situation is under control, referring to how some of the latest government steps such as indexation of MNEREGA wages to CPI-AL, ballooning subsidy bill, etc are complicating demand management. RBI noted that inflation management would be difficult in the face of the government faltering in its fiscal consolidation plans.

RBI would continue to hope that the current tightening phase of monetary policy serve the purpose of preventing the persistent food and energy inflation from spilling over into more generalised inflation. But RBI cant be very harsh with monetary policy. Issues such as the high current account gap can be addressed by raising interest rates but this, RBI feels, will affect growth and can have a significant impact on the capital inflows, asset prices and also on fiscal consolidation, thus aggravating the risks of uncertainty on economic stability. As per current understanding, RBI is likely to move its Repo rate to a peak of 7.25-7.5% but would like to do this in only calibrated doses of 25 bps each.

* The author is chief economist Kotak Mahindra Bank