On 27 October, when RBI governor D. Subbarao presents the review of the monetary policy, it will be a close call. The governor has raised the issue of a timely exit from the current accommodative stance of the monetary policy at various forums. Recently, at the G-30 international banking seminar in Istanbul, Subbarao talked about five concerns specific to the Indian economy, the biggest among them being when to move out of the current loose monetary policy in view of rising food price inflation even as growth recovery is weak.

Whether the RBI decides to tighten the screws this time, or decides to wait for another quarter, is largely an academic question, as indicators are pointing towards a tight monetary policy. Inflation based on the consumer price index is running into double digits and poor monsoons may not allow it come down any time soon.

Even with concerns on growth, central banks generally do not let inflationary expectation build up for long. It’s not a question of if; it is now a question of when the RBI will intervene.
A section of economists believes that it is too early and growth will suffer if the RBI starts raising interest rates now as credit will become more expensive. They might be correct in their observation, but as the RBI is also responsible for price stability, it may not wait for very long. High inflation brings with it various other problems. For example, it creates ambiguity in policy decisions. In absence of clear directions, people are not able to plan for the future, which results in lower investment and growth.

The division in opinion as to when the RBI should exit is based on a number of factors. The problem is that the monetary policy will have to be reversed before its benefits transmit into the real economy. The lending rates did not decrease to the desired extent. As the governor noted in a remark, while the RBI cut policy rates by 575 basis points, banks reduced the lending rates by only 100-275 basis points.

There are a variety of reasons for this stickiness. A major one being that the higher rate offered by small savings instruments such as Public Provident Fund (PPF) does not allow banks to cut deposit rates below a point and the large government borrowing is pushing up yields in the bond market, which affects the lending rate.

If the RBI now raises rates to curb inflation, it will not only hurt growth, which is making a fragile recovery, but also bring in a range of other problems. In search of higher yields, there could be a sudden jump in the inflow of foreign capital, which will result in appreciation of the Indian rupee and hurt exports. Stocks from the IT and textile sectors, for example, will bear the consequences as these companies will earn fewer rupees per dollar of export.

If the RBI intervenes in the exchange rate market to keep the rupee stable by buying dollars, it will increase the money supply, which can lead to an increase in inflation, the problem it is trying to address in the first place.

Therefore, apart from growth, a number of other challenges will have to be addressed. Although analysts believe that rates may be left unchanged this time round, the outlook is towards higher rates. So, investors will not only have to prepare for higher rates, but will also have to keep an eye on the exchange rate.

rajeshkumar AT outlookindia DOT com