Negative inflation may pose dilemma for RBI on key policy rates

Negative inflation may pose dilemma for RBI on key policy rates
The Hindu Business Line, April 21, 2009, Page 1

Our Bureau, New Delhi

With inflation likely to turn negative before the month-end, the question, say some economists, is no longer one of whether to reduce the reverse repo rate, but by how much. This crucial policy rate – which is what banks earn from parking their funds with the Reserve Bank of India – is currently 3.5 per cent.

That the country, for the first time since 1975-76, is going to witness negative inflation based on the wholesale price index (WPI) could impinge on the options before the RBI Governor, Dr D. Subbarao, when he unveils his annual credit and monetary policy on Tuesday.

The Centre would like to see a cut of 100 basis points in both the reverse repo and the repo rates (the latter is the rate at which RBI lends to banks). The Prime Minister, Dr Manmohan Singh, recently told top Indian businessmen, “With ample liquidity and low inflation, there is scope perhaps for a further moderation in interest rates”.

This has been interpreted as a virtual directive to the RBI.

According to the Chairman of the Prime Minister’s Economic Advisory Council, Dr Suresh Tendulkar, “If banks want to stay in business they should start lending. The credit-deposit ratio has been steadily coming down.” Some economists feel that a cut in the reverse repo rate is required if banks were to be prodded to lend more rather than park their surplus cash in the RBI’s reverse repo window.

However, Mr Devendra K. Pant, Director, Fitch Ratings India Pvt Ltd, felt that it would be difficult to bring down the reverse repo rate as it is tied to the savings bank deposit rate (which is also 3.5 per cent). “There will be some tinkering in certain policy rates, but no big ticket changes,” he noted.

Crisil’s Principal Economist, Mr D.K. Joshi, expected the RBI to go in for 25-50 basis point cut in repo rate, while retaining the reverse repo rate at 3.5 per cent.

The RBI may come up with other measures to discourage banks from using the reverse repo window.

These could take the form of quantitative limits, such as ceilings on the amount that a bank can park under the reverse repo window. The option of closing the reverse repo window for a few months could also be considered.

The RBI’s real dilemma arises from the likelihood of negative inflation and the real (inflation-adjusted) interest rate, which is already over 12 per cent.

Starting from this week the official wholesale inflation could enter negative territory and remain there for several months because of the base effect.