Anchoring inflation at the cost of growth?

The first quarter review of Annual Monetary policy for the year 2008-09 came above the market expectation. The market expected a rise of 25 basis point in repo rate, which was hiked by 50 bps to 9.0% with immediate effect. This short-term rate at which the RBI lends cash to banks was last raised on June 24 by 50 basis points to 8.5%. The move is directed at cooling inflation that is running above 11.80% on an annual basis by containing demand.

The central bank has also raised the CRR (percentage of banks' deposits which they must keep with the central bank) by 25 basis points from the existing 8.75%. This will come into effect from August 30.

The reverse repo rate (the short-term rate at which the central bank absorbs cash from the market) remains unchanged at 6%. It has also held the Bank Rate (rates used to price long-term loans to firms and individuals) steady at 6.0%.

The RBI has maintained hawkish stance and given high priority to price stability, anchoring inflation expectations and orderly conditions in financial markets. This while sustaining the growth momentum.

The fresh hikes in rates have come at a time when previous hikes started showing their impact with inflation slightly moderating to 11.89% for the week ended 12 July 2008 above the previous week's annual rise of 11.91%. The twin hikes follows RBI’s assessment that inflation will remain high for some more time given the high global food and crude oil prices.


The rates hike will tighten liquidity in the system, making bond yields to rise. The investors’ fret of liquidity will part ways from Government securities making them unattractive investments. The prices of government securities remained bullish on 28 July since the market discounted a 25 basis point hike in the repo rate and unchanged cash reserve ratio in the monetary policy to be announced by the central bank. This led to buying demand, especially in the benchmark ten-year paper.

The bullish sentiment was further reinforced with the macroeconomic review of the Reserve Bank of India on the eve of its monetary policy review. In its review, the RBI has brought down its growth forecast to 7.9% from the earlier 8.1%. Since the growth forecast is moderate, the market assumed that credit offtake will be modest and in turn investments in government securities will grow. The prices of ten year benchmark 8.24% 2018 rose by 20-30 paise and therefore the yields fell from 9.17% last week to 9.07% on 28 July.

However, with the hike in key rates bond yields spiked up sharply to just short of seven-year highs. The yields are expected to remain firm and bond prices will move southward. The call rates may again zoom over 9%.

Also the rate hikes could lead to banks raising their deposit and lending rates again. However if the lending rates go up the credit demand may squeeze. The bank credit of all schedule commercial banks has witnessed acceleration in the month of June over last year (based on the week-on-week data) on above-normal demand from oil companies (as well as a degree of base effect). It will dent consumer sentiment, dampen housing demand, expansion plans of India Inc. and demand for inputs from cement to steel could slow growth more sharply when global environment is also uncertain. Growth has, in fact, already slowed down due to the tight monetary policy maintained by the RBI in the past year, as is borne out by the tempering GDP growth rate and IIP data. M3 yoy growth at 20.5% remains obstinately above the RBI’s comfort zone of 16.5-17%.

Thus overall the hike in rates by RBI can be seen impacting the economy in two ways. Firstly, reducing demand and thus anchoring demand driven inflation and secondly, impacting the economic growth which is already witnessing signs of moderation.