Tuesday, November 8, 2011

Interest rate hikes: Has the time to apply brakes arrived?

The RBI interest rate policies despite evincing lots of interest have become predictable off-late. Given the fact that the last 13 revisions have resulted in rate hikes, there is an understandable gloom associated with it. Our personal loans are getting costlier, buying your dream home isn’t easy, budding entrepreneurs have seen the cost of capital head north etc. Before we discuss further, let’s first try to understand the rationale behind these rate hikes by RBI. 

The policy being referred to is “Monetary policy” by which the monetary authority of a country like RBI, controls the supply of money by controlling interest rates; monetary base and reserve requirements. The policies are designed keeping in mind, the rate of economic growth, inflation, unemployment or exchange rate. The current RBI policy also referred to as contractionary policies, seeks to address the high inflation levels in India by suppressing demand. The rationale is that higher interest rates would lead to less borrowing thereby reduced investments and demand for capital goods. In addition, higher interest rates will also lead to people saving more thereby reducing consumption i.e. demand.  

Seems logical and sound, isn’t it? It is, but empirically it has been established that monetary policies are effective in targeting price stability, exchange stability and financial stability in short term or at best medium term. The Reserve Bank has so far, hiked its key policy rates 13 times, totaling 350 basis points since March 2010 i.e. the hike has been continuing for more than 18 months.  

While one can't deny that inflation as an issue should be the topmost priority but the results don't suggest that interest rate hikes are helping. Instead it has created hindrance for fresh investments and the impact is all but obvious, in the form of slowdown in industrial growth. As the figure above shows that interest rates for other emerging countries like Brazil and China seems to be heading downwards or flattening but by no means are these countries doing any worse than India.

Experts have been saying for a while that India’s supply constraints won’t allow it to achieve a GDP growth rate beyond 9% as this would lead to excessive demand which our existing infrastructure is simply not capable to handle thereby leading to very high rate of inflation. This phenomena is also referred to as overheating of economy. Thus it’s a structural problem, rather than a cyclical issue, and can't be handled by monetary policies alone. The pictorial description above clearly shows that with rising income, it would be hard to suppress demand. Even the credit growth which was expected to head downward due to rate hikes, has witnessed a healthy y-o-y growth rate of 18-20% (above RBI’s comfort level of 18% or below).  So, one can see that the monetary policies are not achieving even the immediate goals i.e. curb demand and reduce credit growth, forget about reducing inflation. 

As chief economic advisor Dr. Kaushik Basu says in this article, there is a need for an out-of-the-box thinking and that might call for sound efforts on the fiscal front. Sometimes “doing nothing” can be an option and “not increasing rates” might just be that “doing nothing” as it seems RBI doesn’t want to give wrong signals by lowering the rates.

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