Good monsoon for lower interest

Updated on May 19, 2007 01:40 AM IST
Inflation was already on the way though it was below the target set by the RBI, writes DH Pai Panandiker.
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None | ByDH Pai Panandiker

The RBI has been at it since April 2005 when it increased the reverse repo rate to 5 per cent. This was in fact a delayed action on its part. The commercial banks had already put up their rates following the persistent high expansion of credit which had brought investment in government securities to the bare minimum.

Inflation was already on the way though it was below the target set by the RBI.

Over the next two years, the interest rate was increased, hesitatingly at the beginning and aggressively since May 2006 when inflation looked rather threatening. The last time the rate was increased was in March 2007. Since the middle of April inflation has somewhat eased. From the peak of 6.4 per cent it came down to a little over 5.5 per cent. That should give some comfort to the RBI although it may not still be the time for any reduction in interest rates. But with the easing of inflation, the RBI may not increase interest rates further.

There is also an international dimension to be looked at. Even our domestic interest rates cannot be decided in isolation because we are more or less an open economy. There is a good chance that internationally interest rates are likely to drop.

The US economy is slowing down and a reversal of interest rates is quite likely. The European Central Bank may however increase the rate though it is still far below the rate in US. In Japan interest rates continue to be close to zero in spite of the keen desire on the part of the Bank of Japan to lift it up. It is the excessively low rate in Japan that has given rise to financial arbitrage. The game is to borrow in Japan to invest in US and pocket the difference in yields.

By and large, interest rates should be coming down in the international market. That gives the RBI more degrees of freedom to manipulate the domestic rates to conform to domestic conditions.

Although inflation has eased it is not certain whether it reflects a long term trend. The latter will very much depend on developments in agriculture. In the last twelve months prices of food increased more than 10 per cent while those of manufactures rose only 5 per cent. Broadly, inflation in agriculture was due to shortfall in supply and in industry due to excess demand. The RBI will like to convince itself that agricultural production will increase to back up the supply side of market equation.

It is therefore unlikely that the RBI will initiate any change in interest rates before assessing the state of the monsoon. That would mean that the market will have to wait till August for the next interest policy initiative. If the monsoon turns out to be good, which is what the IMD predicts, a reduction in inflation and consequently in interest rates will take place.

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