Will he or won't he? That's the 25 basis points (or is it 50 basis points?) question Reserve Bank of India Governor Y V Reddy will answer on October 26 when he unveils the midweek review of the annual monetary policy.
Ten of the 12 analysts with banks and brokerages at a Reuters pre-credit policy poll last week expected the Indian central bank to keep official interest rates steady and only two of them anticipated a rise of 25 basis points in rates (a basis point is one-hundredth of a percentage point).
The overnight repo or repurchase rate -- at which the RBI sucks out liquidity from the system -- is now at 4.50 per cent and the benchmark bank rate is at a three-decade low of 6 per cent.
The last time the central bank tinkered with any rate was in August last year when it cut the repo rate by 50 basis points, from 5 per cent to 4.5 per cent. That was before Reddy took over as the RBI governor last year.
Ever since Reddy has been at the helm, rates have not changed. However, he hiked the banks' cash reserve ratio by 50 basis points in two stages to 5 per cent to tackle the rising inflation.
The 50 basis points hike in CRR has sucked out around Rs 8,750 crore (Rs 87.50 billion) liquidity from the system. Will the governor hike the repo rate by at least 25 basis points when he unveils the mid-year review of the annual policy? Or, will he prefer to maintain the status quo?
Before answering these questions, let's first take a close look at the two policy documents released by Reddy last November and May this year.
In his first policy, Reddy raised the GDP growth forecast, pared inflation projection and left interest rates and CRR unchanged. The focus, then, was on adequate credit flow to small business and agriculture sectors at the right price.
"If the policy framework has served the economy so well, and as of today [Bimal] Jalan's policy has delivered more than promised, this is not the time to tinker with the rates unless necessary," Reddy had said after the policy was released last November.
His second policy in May this year -- for 2004-05 -- did not have any surprises, either. The rates were not tinkered with and the policy document was a statement of continuity.
Reddy himself described the policy approach as "status quo" and said the overall stance would continue to be the provision of adequate liquidity to meet credit growth and support investment and export demand, while keeping a close watch on price movements.
He had also said that the central bank would pursue an interest rate policy to support the growth momentum and price stability.
Although the policy document took extensive note of the rising international rates and called for a close watch on inflation, a rate hike was not considered because the positive domestic factors such as macroeconomic stability far outweighed external uncertainties.
The first sign of change in the policy stance was seen in the central bank's annual report (2003-04) released in August. By this time, global oil prices had started shooting up and the wholesale price-based inflation had crossed 8 per cent.
The annual report said, "Although the policy objectives remain rooted in the domestic macroeconomic circumstances, the process of monetary policy formulation has to factor in global macroeconomic developments. . . international price trends and movements in international interest rates and exchange rates."
The pursuit of price stability remained a key objective of the monetary policy but at the same time the report called for a "carefully crafted strategy in which monetary policy will not only need to address the demand side of the economy but also strike a fine balance in assessing the supply side of inflation, while enhancing prospects for growth."
This is the toughest task for any central banker: balancing between inflation (both the demand pull and the supply shock) and growth. Tomorrow, Reddy will have to choose one of the two -- price stability or growth. On his choice will depend whether we will see a hike in rates or not.
Reddy moved to Mint Road at a time when all macroeconomic parameters were in the pink of health. The inflation rate was below 4 per cent, interest rates were at their historic lows and foreign exchange reserves were above $85 billion.
There was plenty of liquidity in the system and the level of confidence of foreign institutional investors in Indian markets was high. Now, the pile of forex reserves is higher at $119 billion and despite the CRR hike, there seems to be no strain yet on the liquidity front.
But the bond yields have gone up even though there is no change in the official rates of the Reserve Bank. The joker in the pack is the rising inflation, largely triggered by a rise in international oil prices.
The vulnerability of oil-importing countries to higher oil prices varies markedly, depending on the degree to which they are net importers and the oil intensity of their economies.
A recent analysis by the International Energy Agency of the impact of high oil prices on the global economy said that Asia as a whole, which imports the bulk of its oil, would experience a 0.8 per cent fall in economic output and a one percentage point deterioration in its current account balance a year after the price increase.
It also said that Asia will experience the largest increase in inflation in the first year, on the assumption that the increase in international oil prices would be quickly passed into domestic prices.
It can shave off one percentage point from India's GDP and add 2.6 per cent to the inflation rate.
This is the RBI's biggest worry. With the rising oil price threatening to dent growth prospects, the central bank may feel tempted to refrain from a rate hike because that will be a double whammy.
Corporations that have already started bearing the brunt of higher input costs on account of rising oil prices may find it difficult to stomach a rate hike and may consequently shelve their investment plans.
A survey by the Centre for Monitoring Indian Economy has shown that the total outstanding investments in various projects rose by 14 per cent to Rs 16.3 trillion ($356 billion) in the year to July 2004, compared with a decline of 5 per cent in the same period a year earlier.
If the momentum has to be sustained, the RBI may have to choose to support growth over price stability and hence keep interest rates on hold.
Prime Minister Manmohan Singh, too, might have had this in mind when he said that a rate hike cannot be the answer to the supply-driven surge in inflation.
Singh is possibly still haunted by the spectre of the monetary tightening excesses done in the mid-1990s (when he was finance minister), which led to a recession.
The inflation rate went up from 6.5 per cent in 1993, to cross 14 per cent in May 1994, forcing the then RBI Governor C Rangarajan to tighten the monetary policy. The lending rate by commercial banks soared to 20 per cent, thus crippling the post-reform industrial recovery.
Wiser with experience, the RBI will certainly avoid the sledgehammer approach. At the same time, Reddy may like to be seen to be doing something to manage inflationary expectations without hurting the prospects of growth.
If he follows this path, a small dose of hike in repo rates -- say, 25 basis points -- is possible. This also suits Finance Minister P Chidambarm's idea of a measured policy response.
This will not derail the low interest story and will, at the same time, send a signal to the market that the Indian central bank is ready to rein in inflation rates that are going up both on account of supply shocks and demand pressures.
The bond market has already factored in a small dose of hike and a crash in prices of government securities seems to be unlikely.
The US Federal Reserve has hiked its base rate from 1 per cent to 1.75 per cent in three stages since June this year. It may raise it to 2 per cent by year-end.
Even with a lag, the RBI may follow a similar approach if it does not want to be perceived as a soft central bank. Only a overheated economy will call for a drastic hike in rates. India has not reached that stage yet.
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