Why the RBI should resist the temptation to raise interest rates....
Written by The Indian Express
3 min read
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A monetary policy announcement by the RBI is due next week. In the context of high inflation rates the question on everyones mind is whether the RBI will raise interest rates or the cash reserve ratio again. The RBI has already moved away from the easy money policy that followed the global financial crisis. A mid-policy interest rate hike has added to expectations that it will further hike rates. The clamour from analysts and bank economists for another rate hike has become louder. But should the central bank hike rates?
As the RBI moved barely a few weeks ago,the best policy would be to wait and watch. The difficulties in the transmission mechanism of monetary policy mean that its not clear how much and how long it would take for higher policy rates to get transmitted to higher bank lending rates. Further,its not clear how this would impact credit growth. The lending channel of monetary policy has,in the past,been weak. Credit growth has recently started picking up and this has been seen to be a positive signal for growth and investment. It should be seen what the credit growth will be after the rate hike is fully transmitted in the system before another increase.
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The second challenge higher interest rates raise for the RBI is the impact on the interest differential. The US is maintaining its loose monetary policy stance. An interest rate hike in India increases the interest differential and makes the rupee a more attractive asset. This is expected to increase capital inflows. If the RBI intervenes to prevent rupee appreciation it will end up with an addition to foreign exchange reserves. This will increase the monetary base and the RBI will have to find ways to sterilise its intervention by selling government bonds MSS. The governments large borrowing programme means that the RBI is already selling more government bonds than it ever has had to in the past. Interest rates on government bonds are already on the rise and the appetite of the bond market for more bonds is limited. Intervention and the attempt to prevent intervention also raise expectations that when difficulties of intervention increase the RBI will let the rupee go. This makes the rupee a one-way bet and more capital comes in on the expectation that the rupee will appreciate. This will make the challenge greater.
