One of the basic lessons in macroeconomics that I learnt at university (or perhaps one of the few that I remember) was that monetary policy works effectively only when it is unanticipated. Some of the analytical reasoning behind this is pretty complex but the bottom line is the following.
Central bank action like a cut in interest rates is effective only if it takes economic agents by surprise. Otherwise, these agents tend to factor in the policy action beforehand and adjust their behaviour accordingly. This renders the policy impotent when it is actually announced.
The US Fed (the Federal Reserve Board for the uninitiated) under Chairman Greenspan has turned this paradigm on its head. Fed action has become almost completely predictable and the US central bank seems to actually fall in line with market expectations rather than catch the market by surprise.
The RBI is a little less predictable and there's still an element of suspense in trying to guess its moves. This keeps central bank watchers like me in business and gives me reason to write a piece on what on surprises the mid-year monetary policy due on October 25 could hold.
Quite a large number of market players in India seem to believe that the RBI should turn into some sort of a Fed clone. Thus, as long as the US monetary authority keeps hiking the policy rates (the Fed Funds rate, to be specific), the RBI should also keep tightening its monetary levers.
Thus, going by this argument, the domestic central bank would hike the signal rate (the reverse repo rate -- the rate at which banks can park their short-term balances with the RBI) perhaps by a quarter of a percentage point.
Members of the "follow-the-Fed" school also argue that domestic demand conditions are strong and that could induce inflationary pressures if there's too much money sloshing around. Thus, the central bank should pre-empt these price pressures through monetary action, i.e. a hike in rates.
Besides, if the US were to continue to hike rates and India falls behind, it would squeeze the interest rate differential between the two markets. As US rates inch closer to Indian rates, the incentive of the corporate sector to borrow abroad and spend in India diminishes. This could, over the medium term, affect fund flows into India and also affect the long-term balance of payments position adversely.
The other view (that seems to be in a minority at this stage) is that despite the strength in the macro numbers, inflationary pressures aren't exactly strong enough to warrant a rise in the policy rate. The economy has seen significant structural changes in the system and this has reduced the "pricing power" of companies considerably. Since I subscribe to this view, let me try to support my case.
Since fluctuations in agricultural product prices are largely driven by supply shocks, the only bit that monetary policy can hope to really have an impact on are manufactured product prices. The wholesale price index for manufactured products has risen by less than a percentage this year in the April-September period, its lowest rise in the last four years. This certainly does not warrant remedial monetary action.
Of course there is the possibility that producers affected by the rise in fuel costs could pass the increase on to the end-consumer and stoke inflationary pressures. This is a tricky issue. Past evidence points to the fact that a rise in the price of oil tends to harness industrial growth and demand in general.
This itself makes the business of hiking consumer prices a tad more difficult. Thus, a hike in fuel prices arrests the growth momentum and reduces pricing power. In fact, the RBI has to be careful not to set off an industrial slowdown by compounding the negative impact of the oil "shock" with an interest rate shock.
I would argue that the central bank should give itself a little more time to gauge the oil shock impact on demand and supply conditions before it takes a call on a rate hike. It can, if it wants, hike policy rates at any point of time. If it wants a formal policy forum to make its announcements, the quarterly review in January is not too far away.
I would add two more reasons to keep interest rates from firming up too much. The central government has an active borrowing programme for the second half of the fiscal. In the absence of significant expenditure compression, one of the few ways in which we can keep the fiscal deficit under some sort of control in the medium term is to keep the cost of government borrowing as low as possible. A rate hike certainly won't help this objective.
Secondly, I would also argue that despite the apparent overflow of liquidity in the money markets, a number of banks have seen a sharp rise in the cost of funds as deposit growth has shrunk. A steeper rise in these costs (that a rise in the policy rates would induce) would squeeze bank margins further. This might induce banks to go a little easy on asset growth particularly in high-risk areas like the small- and medium-scale sectors. That's certainly something the central bank would want to avoid.
Having said all this let me end by saying that Governor Reddy's final decision would rest on events in the currency market. The rupee has tumbled quite a bit over the last week on fears of a widening current account deficit and dwindling portfolio inflows. If the jitters continue and the currency goes into a tailspin, there might not be much of an alternative to a rate hike to stem a possible run on the rupee.
The author is chief economist, ABN Amro. The views here are personal.
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