External affairs

It was widely expected that the RBI would move to hike interest rates in its monetary policy review for the first quarter of 2010-11 on July 27. Instead,the central bank decided to hike both the repo and reverse repo rates by 25 basis points each almost four weeks before that review on Friday last week. Clearly,the RBI remains seriously concerned about inflation which continues to persist in double digits. The core of the inflation problem continues to be in food items,even though the rate of food inflation,measured year-on-year,dropped to 12.92 per cent for the week ended June 19,down from 16.9 per cent in the pervious week. That fall,however,is primarily on account of a base effect and the RBI is worried about some spill over inflation beyond food into other areas that would require it to initiate demand management.

There is still little evidence of the economy overheating in the sense of excess demand,and the RBIs relatively moderate hike in interest rates is probably an attempt to send a signal to anchor inflationary expectations,rather than an attempt to squeeze demand straight away. Growth has recovered smartly in the most recent quarters,as has performance of manufacturing,and that gives the central bank some leeway to tighten rates. Interestingly though,the RBI has left the cash reserve ratio CRR unchanged. The system is a little tight on liquidity,one of the reasons for which is the large outgo on payments for the 3G auctions.

Moving forward,there seems little alternative for the RBI but to raise rates in a gradual manner as recovery in growth gets even stronger. There is one important caveat though,a potential external shock. There is much discussion in the West over the prospects of a double dip recession,given the continuing debt problems in Europe. The EU and IMF may have arranged a temporary rescue package for Europes most stricken economies but the kind of cuts required to curb deficits and debt in much of Europe will extract a heavy price on European growth. That will have a spillover effect. That,however,may be a better outcome for the world as whole than a sovereign debt default in even one single country that could potentially debilitate prominent banks and the entire financial system all over again,causing a double dip recession. We know from experience that India is not decoupled from what happens elsewhere so the RBI must keep a close watch on external events before it decides to further tighten the screws at home.