Inflation is the enemy, what the RBI can do?

The Reserve Bank of India (RBI) has done what was expected of it: it has raised the repo rate — the rate at which banks borrow from the Central bank — by 0.25% to 5.75%, and the reverse repo rate (the rate at which banks park money with it) by 0.5% to 4.5%.

On the face of it, the signal is a bit perverse, since double-digit inflation calls for a sharper hike in bank landing rates. But there are two reasons why the RBI has raised its borrowing rate more than its lending: One, banks are already running short of cash, thanks in part to the huge loans they made to telecom companies for the 3G and broadband wireless auctions at a time when deposit growth was slowing down; two, the gap between the RBI’s borrowing (reverse repo) and lending (repo) rates was too wide (1.5%) to be useful as a policy signal. The larger rise in the reverse repo rate vis-à-vis the repo suggests that the RBI no longer wants the corridor between the two rates to become a chasm.

The Central bank also has not raised the cash reserve ratio (CRR), its earlier signalling device. Now that money is already tight after the telecom auctions, and given the fact that economic growth is pushing up demand for bank credit, a hike in CRR would only have made things worse. The RBI, obviously, does not want to hurt growth (or bank bottomlines, for that matter) by crimping credit flows too quickly or too soon.

What is clear from the policy review is the focus: inflation is the chief concern, and growth less so. Governor Duvvuri Subbarao says as much: “With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations.” That the monetary policy hasn’t quite done that is clear from the small hike it has announced, but here again there is some logic to the governor’s call. Inflation is today as much supply-constrained as demand-driven. While agricultural growth has lagged demand for food, capacity constraints are building up in meeting demand for manufactured goods.

Given these supply-side issues, clamping down on demand by pushing up interest rates sharply may send panic signals rather than positivity. So, overall, Subbarao’s stance is more or less what the doctor ordered. He is sending a steady message about inflation, but he does not want to rock the economy’s boat just yet.