The Reserve Bank of India (RBI) is playing catch-up with inflation.
The 50 basis points hike inthe reverse repo rate and the 25 bps hike in repo rate bares urgency in acknowledging that its inflation forecasts were completely wrong.
The RBI has revised its inflation forecast steadily upwards over the last four policy reviews and the wholesale price index inflation has surprised on the upside by almost 5%.
Clearly, the end of policy accommodation was too slow, in line with its way-off-the-mark inflation forecast.
The latest round of rate hikes brings the overall rate hikes to 125 bps on the reverse repo, 100 bps on the repo and 100 bps on the cash reserve ratio.
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The RBI’s forecast for March 2011 inflation is 6% (revised upwards from 5.5%) and to achieve this target, it has signalled further rate hikes lie ahead.
The intention of the RBI in containing inflation expectations is honourable and the fact that it has made it its mandate at present reflects the seriousness.
However, exhibiting urgency when inflation has risen beyond comfort can have the wrong rub-off.
Tuesday’s rate hikes come in a tight liquidity situation, which, in itself, is a form of rate hike.
And the tight liquidity is becoming structural in nature than a temporary effect of money moving into the government’s coffers through telecom spectrum auction and advance tax payments (totalling Rs130,000 crore).
Slow growth in bank deposits (at 14% growth is down almost 6% year on year) and a widening current account deficit (at 2.9% up by 0.6% year on year) are placing upward pressure on liquidity.
The RBI sounds optimistic when it forecast a GDP growth of 8.5% and money supply (M3) growth of 17% and credit growth of 20%, especially when it is in normalisation mode.
It looks like the central bank will get it wrong on inflation on the way down, just as it got it wrong on the way up.
It will continue its tightening policy as WPI numbers come in at higher levels, but will be reluctant to revise forecasts downwards even if domestic growth prospects get hit on global factors and commodity prices trend down on slowing demand.
In effect, the tightening will come at a time when growth prospects trend down and inflation expectations also trend down.
That is the price to pay for being behind the curve.
