The case of the curious rate hike

Updated: Jun 13 2006, 05:30am hrs
Inscrutable. Thats how most central bankers like to see themselves. Alan Greenspan is their ideal. Often accused of being incomprehensible in his public utterances, he once famously told a senator: If you understood what I said, I must have misspoken. By that criterion, Reserve Bank of India (RBI) governor YV Reddy did himself proud. On Thursday last, he lived up to the image of archetype central banker, raising interest rates when the move was not only least expected but, more important, made little sense, given that the efficacy of such policy moves has as much to do with timing as with content.

Analysts have tried to find logic in the banks terse statement that the decision to hike the reverse repo (the rate at which the RBI drains out liquidity from the system) and the repo rate (the rate at which it pumps in liquidity into the system) was taken on a review of current macroeconomic and overall monetary conditions. Most of them bought the banks argument that the increase was necessitated by the series of interest rate hikes by central banks across the world and the rise in inflation rate.

Never mind that in the past, RBI has often ignored rate hikes by central banksthe US Fed has raised rates 16 times since mid-2004; during the same period, RBI has hiked rates only six times. Never mind that RBI itself has often argued that it is supply, rather than demand-side factors that are primarily responsible for inflationary pressures. Never mind also that as far as macroeconomic and overall monetary conditions are concerned, nothing has really changed since mid-April 2006, when the same RBI opted to mark time and refused to raise rates.

Sure, inflation is up marginally. The annual wholesale price index rose 4.74% in the week ended May 20, compared to 4.32% the previous week (though the subsequent week showed a slight fall) and is slated to go up further, once the effects of the recent hike in petrol prices percolate through the system. But it is not as though inflation has suddenly picked up. On the contrary. Rising global crude prices had already impacted the system, but their effect was hidden in the form of huge under-recoveries of oil companies and subsidies and was not explicit. The only difference between April and June, therefore, is that with the government finally hiking petrol and diesel prices, the impact of rising crude prices will become more explicit. It will be reflected in the wholesale price index.

But central banks dont act on the basis of explicit numbers alone. They are expected to respond well before such numbers become explicit public knowledge. Their job is to pre-empt, to be ahead of the curve. By which logic, the RBI ought to have responded much earlier. More so since the monetary policy arrows in its quiver are blunt, will take time to make their impact felt and given that the economy is showing signs of peaking, will in all likelihood strike home much later, possibly in the midst of a slowdown.

The RBI opted to leave interest rates unchanged in April 06
Nothing has changed since April to justify the recent hike in these
Quite possibly, the RBI is making up for lost time
Even in developed markets like the US, it is estimated that it takes close to two years for the full impact of a Fed rate hike to percolate through the system. That is the reason why the US Federal Reserve commenced its tightening cycle in mid-2004, well before inflation began showing signs of edging up and the current account and budget deficits were nowhere near their present danger levels.

The fact is the reverse repo rate is a blunt instrument for controlling inflation in the short term. Consequently, the complete impact of Thursdays rate hike will not be felt immediately but a good year or two down the line. Maybe even more, given that our markets are nowhere as developed as in the West and our transmission mechanism is also much weaker. It is also important to remember that though we began our tightening cycle in mid-2004, more or less at the same time as the US Fed, the Fed has moved far more decisively to hike rates from 1% to 5% in a series of deliberately planned, regular moves that markets could factor in. In contrast, the RBIs actions in pushing up the reverse repo rate from 4.50% to 5.75% have been more spasmodic.

The result is not only that markets have been caught on the wrong foot, as evidenced by the mayhem in the bond market that followed the latest hike. There is also the very real danger that the RBI, far from being ahead of the curve, is in fact behind it. In which case, far from nipping an asset bubble in the bud, the impact of the hike may be to aggravate a downturn.

Today, when all of us are basking in the glory of a post-reform record of 9.1% growth in the January-March 2006 quarter and an upward revision in gross domestic product estimates for 2006 to 8.4%, it may seem strangely at odds with reality to even talk of a slowdown. But the signs are there. According to reports, more than 50% of Indian companies saw a drop in profits last year, foreign institutional investors seem to be taking a re-look at the India story and equity markets are in the midst of a harsh correction. Meanwhile, the yield curve, which was flat for most of the last year, has become much steeper, credit offtake has slowed and the rupee has weakened.

In such a scenario, the reasons for the hike seem curiouser and curiouser, as Alice remarked to the caterpillar in Lewis Carrolls Alice in Wonderland. The only charitable explanation seems to be that the RBI knew the interest rate hike was long overdue. But as with petroleum products, the bank was waiting for its political master to give it the all-clear. It got that once the assembly elections were over. And, hey presto, you had the rate hike.