Taking an interest in credit

The credit policy or monetary policy announced every quarter by the RBI is the mechanism through which the monetary policy affects prices and output in the Indian economy. The main channel through which a central bank affects monetary policy is through interest rates, the price at which it lends money to the economy. It raises interest rates when it wishes to reduce inflation, as was done in the policy announcement on January 31.

8226; What happens when interest rates are raised?

When interest rates go up, the cost of borrowing increases. This makes individuals and firms put off some of the expenditure that they may otherwise have undertaken. It may be that an individual was planning to take a housing loan, but a rise in interest rates makes the EMI larger than he can afford at his current salary. This will prompt him to borrow less or not to borrow. Similarly, a firm may have been planning to expand. However, at a higher interest rate, some projects become unviable. In a country of a billion people and a million firms, a small interest rate hike would affect only a small number of borrowers, but it does slow down the economy. When borrowing has already taken place, and a floating rate contract was used, the interest outgo rises with higher rates, thus reducing the money available to spend on other things. The contraction in demand is not immediate, as it takes time for spending decisions to change and for them to have an effect on the economy. In developed countries this channel may take a year or two to have an impact. In India we do not have enough evidence to indicate how long the lag is.

8226; What prompted the RBI to raise rates this week?

The inflation rate based on the consumer price index CPI has been rising in recent months. From a level of 3 per cent in early 2004, the inflation rate based on the CPI for industrial workers rose steadily over a period of 2 years to nearly 7 per cent. Inflation as measured by the Wholesale Price Index WPI also accelerated from less than 3 per cent two years ago to 6 per cent in recent weeks. This sharp rise in inflation is one of the main factors that has led to a hike in interest rates. As Finance Minister P. Chidambaram has often said, an inflation rate of more than 4 per cent is intolerable. Thus the government has to take action to bring down the inflation rate.

8226; But is inflation not a consequence of food shortages and oil price hikes?

Since food and oil prices tend to be volatile, the term 8216;core inflation8217; is used for inflation computed for non-food, non-oil commodities. The WPI consists of three main components. Primary articles that include food articles and commodities constitute 22 per cent of the index, fuel constitutes 14 per cent and manufactured goods constitute the bulk, which is 64 per cent. In recent weeks food prices have been rising the fastest and inflation in oil prices has declined. With manufactured goods, inflation has been rising at a rate higher than 5.5 per cent. So even if we put aside food and oil, inflation exceeds P. Chidambaram8217;s 4 per cent limit.

8226; Who are the gainers and losers from the interest rate hike?

Borrowers will be losers in the immediate future because loans will become more expensive. In the longer run, when inflation comes down, everyone, especially those with fixed salaries, who feel the pinch of inflation will gain from lower price rise. The most important benefit of low and stable inflation is higher private investment with a lower incidence of mistakes. When inflation is low and predictable, there is better certainty about the future in the mind of an investor. Greater certainty allows people to make better decisions about investment. The international evidence shows that when inflation is low and predictable, the fluctuations of GDP growth are reduced, which benefits everybody. The path to stability of the macroeconomy lies through devoting the entire power of monetary policy to one task: stabilising inflation.

8226; Why raise rates at all? Why not just tolerate inflation and enjoy higher GDP growth?

In the short run, it is always possible to squeeze out a little extra growth from the economy by jolting it with higher inflation. The acceleration of the CPI from 3 per cent to 7 per cent has certainly had something to do with the remarkable GDP growth that has taken place in 2005 and 2006. However, 7 per cent inflation is harmful, and the effect on GDP growth is short lived. We get higher GDP growth when inflation rises from 3 per cent to 7 per cent, but not if inflation stays at 7 per cent. If another bout of accentuated GDP growth is desired, another jolt of inflation acceleration will be required, going from 7 per cent to 11 per cent. This style of thinking 8212; of obtaining brief increases in GDP growth by having acceleration in inflation 8212; fundamentally destabilises the economy. High inflation is harmful, politically unsustainable, and costly in terms of growth impact when the time comes to restore low inflation. A much better strategy for macroeconomic policy is to devote monetary policy to one task: that of delivering low and predictable inflation. This is what all mature market economies do.

The writer is senior fellow at the National Institute of Public Finance and Policy, New Delhi