Wednesday, December 18, 2013

Raising Interest Rates: Questionable Tool To Fight Inflation

IndusView, Wednesday 18 December 2013 (London): The Reserve Bank of India (RBI) took the market completely by surprise, keeping the repo rate unchanged in the face of overwhelming expectations of an increase citing the tenuous state of the economy. 

Raising interest rates, however, are likely to be a weak tool to combat inflation.

Increasing interest rates to fight inflation that occurs due to rising demand of goods and services could be effective as it makes credit expensive for purchasers. Surging demand is not the case right now given India’s sluggish economy. When used to combat inflation that’s based on rising costs, however, rate increases are ineffective. India’s inflationary pressures on inflation are due to higher world oil and food prices, value added tax and other tax increases as well as delayed effects of a depreciated currency exchange rate.

“When The RBI increases its interest rates, it’s as if it is using a cat to calm the herd,” said Bundeep Singh Rangar, chairman of London-based advisory firm IndusView. “A belief that raising interest rates will rein in inflation that’s propelled by cost factors is dangerous and ineffective. The only effect will be to suppress growth, something India’s economy can ill afford.”

Estimations of the effects of interest rates on inflation, often carried out within central banks, suggest that the effects are small. A typical finding is that a one-percentage-point higher interest rate maintained for one year could reduce inflation by about 0.2 percent.

Costly vegetables, particularly potato and onion, pushed the November wholesale inflation to a 14-month high of 7.52%. The consumer prices rose 9.84% year-on-year in September, the fastest pace in three months.
“A repo rate cut was needed for growth and other tools could have been deployed to fight the menace of inflation,” said Rangar. Given that growth in the economy is at a low point, business confidence is weak and new investments have ebbed, the new RBI governor should have initiated measures to enthuse the market participants, boost investor sentiment and bring confidence back in the economy.”

Other emerging markets like South Korea have tried another approach, with the central bank leaving interest rates unchanged and increasing their flood of foreign capital, which can help absorb inflationary pressure.

South Korea Central Bank data showed short-term foreign borrowing, mostly by banks, jumped by a net $6.72 billion in March, the third monthly increase in a row and the biggest gain since August 2008.

“India needs to attract more inward investment from its 25 million strong overseas diaspora who sent twice as much money into India last year than FDI and FII combined and better collect tax,” added Rangar.

India's economic growth rate picked up in the most recent quarter, according to official figures. The economy expanded at an annual rate of 4.8% in the July-to-September period, up from 4.4% in the previous quarter. Yet, this is the fourth quarter in a row that India's annual growth rate has been below the 5% mark, and the previous quarter's rate of 4.4% was the lowest for four years.
The World Bank slashed India’s economic growth in its April forecast to 4.7% from an earlier projection of 6.1%, a cut of 1.4 percentage points.