Case for another rate hike: it works only if it hurts

By Madan Sabnavis

It is monsoon time, and the credit policy date of the Reserve Bank of India (RBI) coincides with the day Mumbai was deluged six years ago: 26 July. We can thus draw an appropriate analogy to describe Governor Duvvuri Subbarao’s predicament.

Monetary policy has been likened to driving an automobile on a stormy day witha shattered windscreen and a fogged rearview mirror, with one foot on the brake and the other on the accelerator. The driver, as one can guess, does not really know what to do. Is this the case with the RBI today?

In a way no, because we have industry as well as critics screaming that rate hikes should be ended, or the repercussions will be unsavory. But for policy to be effective, someone must be impacted. It must hurt somewhere. Or else it won’t matter.

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Monetary policy can be said to work if interest rate hikes help to lower the growth of credit which, in turn, reduces the demand for consumer goods such as automobiles and consumer durables and investment goods (machinery). As long as rate hikes do not stop the flow of credit to these sectors, policy is impotent and there is a strong case to go in for further hikes.

Therefore, ex-post, we know that monetary policy is working when industry starts squealing, which it is doing today. But this is not quite supported by the first crop of quarterly results we have seen so far, which suggest that interest rates are impacting costs but have not yet begun hurting growth or bottomlines seriously. Therefore, the RBI definitely has reason to increase rates further until such time that growth in credit gets choked which, in turn, puts pressure on demand for goods and investment.

Inflation so far has been raging across all the three segments: primary, fuel and manufactured products. The last component comprises what iscalled core inflation, where monetary policy really matters.

[caption id=“attachment_47275” align=“alignleft” width=“380” caption=“Every rate hike actually increases the cost of funds, giving little option to banks but to raise lending rates.Reuters”]  [/caption]

Interest rates cannot affect food inflation or fuel inflation, which are caused byeither supply factors (food inflation) or government (fuel and food in the form of administered or minimum support prices). Today, the core inflation number is rising, and this comes directly under the purview of the RBI. Hence, raising interest rates again makes sense.

One can, however, point out that the RBI has been increasing interest rates since March 2010, when core inflation was low at around 3-4 percent. This has crept to around 5-6 percent by March 2011. Now it has crossed 7 percent. Credit growth continued to be buoyant in 2010-11, as was investment andindustrial growth, though, admittedly there was a slowdown over the four quarters.

Industrial growth in the first two months of the current year has been just over 5 percent, and if this slowdown is for real and not merely a statistical blip, then the RBI can rest assured that its policies are finally working.

What about growth? In the May annual policy review, the RBI did mention in a subtle manner that it would not really mind compromising growth to quell inflation. It has put its GDP growth rate at 8 percent, which was 1 percent lower than that of the ministry of financeat the time of the Union budget in February. Therefore, we may assume that the RBI will continue to drive interest rates upwards even at the cost of growth.

The central bank had said that the transmission mechanism of monetary policy was slow; and this was corrected by making the repo rate (at which it lends to banks) the focal rate, raising the interest rate on savings deposits and introducing the concept of the base rate. This has ensured that every rate hike actually increases the cost of funds, giving little option to banks but to raise lending rates.

The possibilities for growth are, however, fuzzy today. Agriculture and services (excluding construction),which account for around 70 percent of GDP, may have a limited exposure to creditas farm credit rates are fixed by the government and the unorganised services component is anyway largely outside the banking system.

High interest rates probably impact sectors such as transport operators (non-banking companies have a say here), real estate and housing, trade (wholesale trade, in particular) and hotels and restaurants. The sectors that do not access the formal channels would be affected also, albeit in an indirect manner, as the unorganised lending sector also raises rates to reflect the cost of money.

Therefore, we may expect the RBI to continue to persevere with rate hikes until such time that inflation, or rather core inflation, comes down. With core inflation being over 7 percent and prices of primary and fuel products in the double-digit region , there is a strong case from the point of view of theory to increase rates further until such time that it hurts. Growth may be compromised, but then that is the tradeoff that we have to be prepared for.

Crimping consumption growth is acceptable in the short run, but the impact on investment is more serious as it affects future growth prospects even after core inflation comes down. If investment slows down, we will have to live with moderate growth in the region of 8 percent for a longer period of time since investment today is essential to create demand tomorrow.

This strategy is risky because economies could just slip into a recession when investment slows down. It gets exacerbated when the government also decides to spend less, which is the case today. At another level, this should be kept in mind when we talk of our five-year plan or else we would be off the mark yet again.

In short, if ever interest rates need to have the desired effect on reducing any component of inflation, it is now. But we should remember that growth could be thwarted. That is the deal.

Madan Sabnavis is Chief Economist at Care Ratings. The views are personal