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Posted by: Deepa Vasudevan on Mon, Sep 23rd, 2013

Why did RBI increase the Repo Rate?

On September 4, 2013, when Dr.Raghuram Rajan took over as the Governor of the RBI, he presented a confident action plan that greatly impressed the market. More good news followed: IIP for July unexpectedly rose by 2.6%, August merchandise exports rose by nearly 13%, and pending bills were cleared in parliament. The rupee began to regain value and the CAD crisis of July seemed to be receding. Markets have short memories: the panic of July-August was put aside.  Between 4-19 September, the BSE sensex rose by 11%.  The Fed decision to continue its liquidity enhancing stimulus alone pushed the sensex up by 3% on 19 September. Expectations that a new monetary easing cycle would start were set up.

 

Competing for global foreign inflows

 

In all this euphoria, three key macroeconomic developments were ignored. First, emerging economies such as Brazil and Indonesia have increased policy rates recently to support their currencies and combat inflation. India competes with other developing countries to attract foreign inflows; in a year where it probably needs $70-$80 billion of inflows to fund its current account deficit, a drop in rates would have made it less attractive as an investment destination.

 

Combating Rising Inflation

 

Second, WPI inflation, which has been declining steadily from August 2012, rose marginally to 6.01% in July 2013, driven by an 18% rise in food prices.  Fuel prices have been rising at 11% for the last two months; the combined impact of a depreciating rupee and domestic price hikes suggest further increases. There is a serious risk that the battle to bring inflation within RBI’s comfort level of 4%-6% may be lost again.

 

Threat of High Fiscal Deficit

 

Third, containing the fiscal deficit within the target of 4.8% of GDP remains a challenge. The Report of the Prime Minister’s Economic Advisory Council (September 2013) pointed out that fiscal deficit during the first four months of 2013-14 had already reached 62.8 per cent of the budgetary provision for the full year. Coming on top of a precarious balance of payments position, a high fiscal deficit carries the threat of a sovereign downgrade.  The fact that the finance ministry announced fresh austerity measures this week reveals that the government is worried about overshooting its target.

 

Given the need to tighten spending and restrict inflationary pressures, increasing the policy repo rate, as Governor Rajan did today, seems to be an appropriate response. Pressures on the exchange rate that were created due to fears of Fed tapering are temporarily off; so the specific liquidity tightening measures imposed on banks have been partly removed. And as inflation rises again, an immediate rate hike should help to suppress inflationary expectations. The 25 basis points increase aligns India’s policy with the rest of the emerging world, and signals that inflation cannot be tolerated.  This is a subtle use of the interest rate tool.  

I P Bharti on Thu, Sep 26th, 2013 3:05:45 pm

"If it is a Demand Pull inflation then hiking the rate is justified but when the inflation is Cost Push because of supply constraint how the rate hike is justified??" Moreover the increase in the inflation is because of food items and we will have supplies in the next couple of weeks which should bring down the food inflation. By hiking the rate we are trying to curb the demand which is not there.. Pl throw some light.

mitesh on Wed, Sep 25th, 2013 9:25:05 pm

I think government also work with different axis. They have to watch on how to increase food price and restrict to cold storage to store food. Last year we saw that lots of potato and tomato and onion on the road. saw work on black mafia and some political person who did it. Automatically our market grownup.

Jitendra Singh Rathore on Tue, Sep 24th, 2013 9:45:46 am

I guess what RBI Governor did is the right thing

P L MITTAL on Tue, Sep 24th, 2013 9:13:21 am

I guess what RBI Governor did is the right thing.After all the country is suffering many economic problems whih to be tackled need a tough posture.

T Dharmaraj on Tue, Sep 24th, 2013 6:37:18 am

The article is informative and timely. At least once at the beginning an abbreviation used in the article could have written in full form. What is IIP?

Gautam Haldipur on Tue, Sep 24th, 2013 2:04:49 am

1.Dr.Raghuram Rajan's maiden Policy announcement increasing the Repo by 25 bps & easing the MSF by 75 bps, is undoubtedly a subtle, sane & very much required balancing act to put things back on track slowly but predictably. The interest rate reduction is going to be slow, painful & unpredictable as it stands today.2. Instead of WPI, we need to have CPI as the indicator of inflation, which is more realistic.3.Rising Inflation--The real culprit has been Food Inflation, which arguably hurts the common man the most. This is a factor which can be controlled by a crackdown on the powers that control this lobby.Ex. Prices of Onion--definitely an artificially inflated price.4. Fiscal Deficit-- Less said the better on this front. We are doing possibly the most ridiculous things like the Food Security Bill which will strain our finances even further & will do no good to the common man either. This is going to generate another cycle of "FOOD CORRUPTION" as is already happening in Karnataka, where reportedly a major portion of the Rice from the Re.1/- per k.g.rice is supposedly making its way to hotels.The political class is doing everything it can with populist measures a-la 2014. Hence, with whatever best you do on the Monetary Front, nothing will be stable as the Fiscal Front is going to continue to be a lame duck. God save this Country! & Dr. Raghuram Rajan too who undoubtedly is a thorough bred Professional with a deep understanding of Economics.

LAKSHMANAN ASHOK on Mon, Sep 23rd, 2013 7:01:53 pm

AS PER MACRO ECONOMICS, WHAT HE HAS DONE IS CORRECT. BUT NO MONEY IS COMING TO BANKS OR OTHER FINANCIAL INSTITUTIONS. ALL ARE GOING TO REAL ESTATE AND GOLD. FOR EVERY PAISA INVESTMENT YOU MUST ADHERE KYC NORMS. BUT YOU CAN BUY GOLD WITH CASH AND NO KYC NORMS. THEN WHAT IS THE USE OF SO MUCH REGULATIONS.ATLEAST IF HE CUT THE REPO RATE AND INCREASE THE LIQUIDITY, THE COMPANIES WHO GOT LOANS WILL GET BENEFIT AND BY THE WAY IT SLOWLY STIMULATE THE CAPEX AND GROWTH.YOU MUST THINK REALTY AND NOT GO THRO THEASIS.

S V VYAS on Mon, Sep 23rd, 2013 4:03:45 pm

it is good that a sense of responsibe action prevale in the mind of MR RAJAN and he come to know the gap of co -ordination between policy maker and monetary agency and try to rectify the same.In future also he sholld not fell to political pressure and take the action as per monetry and economcal situation.

Sandeep Tripathi on Mon, Sep 23rd, 2013 3:28:19 pm

While one agrees to the possible reasons as stated in the blog,the real reason seems to be more driven by the incoming elections in th states followed by the general elections.Not long back both PM & FM were flexing their "reforms" muscle & growth was high on stated agenda.However,with their apparent policy paralysis functioning & widespread corruption & nepotism,inflation soon got back in focus.With a more accomodating governor willing to toe the goverments line,it was not a surprise to see the outcome in the policy review.Fact of the matter is that it exposes the yawning gap of co-ordination between the monetary agency & the policy making body of the country.

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