RBI's impact - Interest rate vs Growth rate

5/23/2011

High inflation negates prospects of growth,” said RBI governor D Subbarao while recently speaking at the Indira Gandhi Institute of Development Research in Mumbai. In a nutshell it reflects the status of the current Indian macro economic situation that has been struggling with high inflation for quite some time. Now add to that the recent price rise in petrol and the expected hike in diesel prices which will further fuel inflation and you would see why the situation is not that comfortable. Persistently high inflation adversely impacts the growth of the corporate sector. Till now we have not witnessed much of an impact of rising inflation and interest on India Inc’s financials but going for-ward we believe it will definitely hurt the growth of the Indian companies.

Prof B B Bhattacharya, economist and former VC, JNU, explains the probable impact of high inflation on Indian companies by saying, “The current phase of inflation is quite disturbing and in the long run it will also impact the sales of the companies.” Therefore, it becomes very important to control inflation and the recent hike in interest rates by the RBI is a step in the same direction. “It is true that there is a short-term impact on some of the sectors like automobiles and housing as borrowing cost would increase for the consumer but overall for every sec-tor it is very much necessary to curb inflation,” he adds. We believe that this will have a short-term impact and particularly so on the interest sensitive sectors. Let us analyse the reasons for such high inflation and why the RBI has to take such actions.

The Inflation Itch
After taking baby steps for almost a year and raising rates by 25 basis points (bps) eight times, on May 03, 2011 the RBI hiked the policy rates by 50 bps. It went in for a higher rate hike this time as the earlier rate hikes had failed to yield the desired result to address the key issue of rising inflationary pressures. Why have inflationary pressures not come under control despite having hiked rates eight times prior to the latest hike? “RBI’s steps are not at all enough to reign in inflation and it needs major policy initiatives from the government as well. In fact there should be a proper coordination between the fiscal policy initiatives and the monitory policy. Only then can inflation be tamed in an effective way,” Prof Bhattacharya opines.

This move has decisively tilted the RBI policy towards curbing inflation, signalling that growth can take the backseat for a while. The current inflationary situation is way above the central bank’s comfort zone of 5-6 per cent. Higher inflation is not the only factor that is disturbing but it is also its stickiness that is frustrating. Headline inflation that is measured by the WPI (wholesale price index) has not come down to RBI’s comfort level since December 2009 and has stayed above 8 per cent consistently from January 2010 onwards. In fact in the last 56 years it is only nine times that inflation has remained at such a high level in double digits. The last time that inflation remained so high was from March 1994 to May 1995.

The current rise in inflation started from July 2009 (-0.62 per cent) from when it started to accelerate while the economy was still recovering from the significant global slowdown. From July 2009 it continued to show rising trends before reaching its recent peak of 11 per cent in the month of April 2010 (see graph). Thereafter, moderating for some time, it again accelerated in the last three months. Inflation for the month ending March 2011 stood at 8.98 per cent. There were arguments that as a higher base effect factors in, inflation will moderate from the first quarter of the CY11. Nonetheless, we are almost five months into CY11 and there is no trace of inflation coming down. This is making the situation even worse. So what are the reasons for the inflationary monster not lying low?