This interest rate hike is like using a sledgehammer to kill a mosquito. Vegetable prices cannot be brought down through interest rates.

July 26 2006: The Reserve Bank of India today raised the reverse repo rate, its benchmark rate, by 25 basis points to 6 per cent. The reason for this is the rise in the Wholesale Price Index over the past few weeks as a result of the increase in the prices of vegetables, pulses, oil and fuel. The last hike in the rate was on June 9, also by 25 basis points. This is the sixth hike in the reverse repo rate since October 2004.

However, two questions need to be asked about the monetary policy:

Will interest rate hikes reduce the current inflation?

Is our monetary policy tracking the right indicator(s)?

Answering the first question, the tendency of most central banks is to raise interest rates when there are signs of inflation. However, if one looks up any textbook in monetary economics, it would become clear that raising interest rates works only if the inflation is `demand-pull'.

What kind of inflation?
Demand-pull inflation, as the name suggests, occurs when the demand for goods exceeds their supply. Therefore, when rates are raised, it reduces the demand for goods and reduces inflation.

However, looking closer at what is causing the rise in WPI, it is clear that it is `cost-push' inflation, caused by supply-side aspects such as a rise in input costs or failure of crops.

When the three components of the WPI are considered, it is clear that the inflation rate is up because of the rise in prices of primary products and fuel, and not manufactured products. Primary products consist predominantly of food articles such as cereals, vegetables and pulses.

It has been widely reported in newspapers that the recent rise in prices of food articles is the result of supply problems and not a sudden demand spurt. However, the fuel and power components are the biggest contributors to the jump in the WPI. Compounding this, the RBI said in its Macroeconomic and Monetary Developments First Quarter Review 2006-07, is that there is yet to be a full pass-through of the high international oil prices.

Monetary Policy usually has no effect whatsoever on this, given that most of our oil requirement is imported and we are price-takers.

Right indicator
The second question is whether the central bank is tracking the right indicator when setting the Monetary Policy. World over, central banks rely on the Consumer Price Index (CPI) to gauge inflation and set the Monetary Policy. The RBI is handicapped as it has to rely on the WPI because of an unacceptable lag in the announcement of CPI numbers.

It is necessary for any central bank to use the CPI as a gauge of inflation because it shows the true impact on consumers as opposed to the WPI. The last CPI number was announced on May 31. When the numbers for that date are compared, the CPI (Industrial Workers) was 6.14 per cent and CPI (Urban Non-Manual Employees) was 5.84 per cent, while the WPI was 4.68 per cent. In hindsight, therefore, the reverse repo rate must be higher than what it is now.

The Reserve Bank of India is faced with a difficult conundrum. It really is in quite a thankless situation, with pressures on several fronts.

There has been considerable pressure on the central bank to raise rates because the headline inflation number, the WPI, has gone up. However, the facts on the ground say that a hike in the interest rates may not necessarily help cool this inflation because it is mostly cost-push inflation.

The other problem the RBI faces is that the US Federal Reserve has been raising rates continuously for the last 17 months. While the Fed chairman, Mr Ben Bernanke, said recently that the hike in the Fed Funds Rate in June might be the last, some analysts think that the Fed is not quite done. The current Fed Funds Rate is 5.25 per cent.
There is a school of thought that the RBI should not track the Fed Funds Rate because it is more reflective of the concerns within the US economy and that the RBI's reverse repo rate should only be reflective of concerns in India. On that count they are partially correct.

While the RBI should be focussed on domestic concerns, it should keep an eye on international interest rates. In this age of free capital flows, an interest rate that is set without accounting for international interest rates could cause damaging arbitrage outflows. Therefore, the RBI has to maintain an adequate premium on the rupee given that India's inflation rates are higher than in the US.

The lag issue
Another problem the RBI faces is the lag issue. While the Monetary Policy has a short inside lag (of recognition and implementation), the effectiveness lag is longer. There is no exact time period when a Monetary Policy takes effect, but the general consensus is around six months. Currently, the RBI is faced with higher-than-optimal inflation and is, therefore, hiking interest rates but there is no clear way of knowing its effect in six months.

Generally, higher interest rates have a cooling effect on an economy that has overheated. However, the problem now in India is that the economy already appears to be cooling from its impressive growth. The Business Confidence Index released by the NCAER has dipped for the first time in four years.

There is also a general consensus among analysts that industrial growth will not be as rapid as in the past few years. This interest rate hike could have the effect of further depressing industrial growth and that is clearly what the RBI should not let happen.

A sledgehammer APPROACH
The RBI has reacted to intense pressure on it because all parties wanted it to do something to reduce inflation. The RBI did the only thing it could do and that was to raise interest rates. But as it is clearly cost-push inflation, this policy may not have the intended effect. However, it is likely to affect industry, which will now face higher capital costs.

Therefore, this interest rate rise is akin to using a sledgehammer to kill a mosquito. The fact is that if vegetable prices need to be kept down, it cannot be done through using interest rates. It is incumbent on the government to provide better storage facilities for vegetables and that is certainly a much better policy action.

(The author is Group Economist of the Murugappa Group, Chennai. All views are personal. He can be reached at sunilrongala@corp.murugappa.com)