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Interest rates may stay high on inflation risks

india Updated: Jul 28, 2007 05:17 IST
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Inflation has been the target of policy for the past one year. Fiscal measures taken by the Government did not prove adequate. The RBI came into the act, though late, and made money costly to calm down inflation. Apparently the strategy worked.

Inflation had peaked at 6.7 per cent last January. It is the market that decides prices, with some exceptions like prices of petroleum products. The market imbalance, which ushered in inflation, was caused by supply limitations and excess demand. Lower customs duties and harder rupee did help increase supplies and check prices but did not add up to a solution. Excess demand reflected in credit expansion by banks therefore became RBI’s policy target to be achieved through interest rate manipulation.

There were two ways the RBI geared up interest rates. It raised the repo rate, the rate at which it lends to commercial banks, from 6.5 to 7.75 per cent and increased the cash reserve ratio (CRR), which is the proportion of deposits that the banks have to keep with the RBI, from 5 to 6.5 per cent. Both measures hardened interest rates. The prime lending rates of banks (PLR) as also the deposit rates rose more than 200 basis points. Banks also devised other short-term schemes (FMPs) for getting over liquidity shortage by paying even higher rates. It took about six months for these measures to show results. The growth of deposits was up from 20 per cent in December to 24 per cent in June and of credit down from 26 per cent to 23 per cent.

Banks are now confronted with the problem of surplus. They receive more money from deposits than there are clients to borrow. In the last six months the additional credit was less than 45 per cent of the additional deposits against the earlier 72 per cent norm. Banks have thus been forced to reduce interest on credit to clear excess liquidity. The excess liquidity was also partly because of foreign investment inflows.

The call money rate is down to less than 0.5 per cent, the PLR by 100 basis points, the 10 year government paper by 50 basis points, and so on. Yields on treasury bills have fallen below the reverse repo and the interest differential between government and corporate securities has narrowed to 1.4 per cent. The market has moved faster than the RBI to adjust to the new liquidity situation. The danger is that it may again stimulate credit expansion and consequently stoke inflation.

The inflation risk persists. Therefore, it is unlikely that the RBI will cut key interest rates in tune with the market. But liquidity has to be mopped up to discourage a rapid fall in commercial banks interest rates and result in rapid rise in bank credit. Hence, the RBI may opt for more intensive use of market stabilisation scheme that will also stabilise the rupee, and increase CRR.

The writer is president, RPG Foundation