The interaction between interest and exchange rates and inflation

Putting to rest all speculation about the extent of monetary tightening, the RBI's annual monetary policy for 2010-11 has raised repo (5.25%), reverse repo rates (3.75%) and CRR (6%) by 25 basis points each. See this superb analysis of the monetary policy by Amol Agarwal and grapic below from Financial Express today.



This hike in repo and reverse repo rates is a clear statement of intent that the RBI is concerned with inflation and is committed to keeping inflationary expectations under control. However, the extent of hike (against say, a 50 basis points increase) indicates that the RBI does not as yet feel the need to embark on aggressive monetary tightening, and that it remains sensitive to ensuring that monetary contraction does not stifle any economic growth prospects.

The extraordinary monetary expansion to weather the contagion effects of the sub-prime crisis is now being reversed by increasing the CRR, so as to mop up the excess liquidity sloshing around. The persistance of large inflows into the Liquidity Adjustment Facility (LAF), despite the increases in the CRR was a clear pointer to further increases in CRR. In fact, there may have been a case for raising CRR by 50 basis points.

In this context, it is important to consider the fact that any monetary policy approach will impact not only on inflation but also the rupee exchange rate, and therefore any interest rate decision have multi-dimensional implications.

1. The WPI-based inflation figures for the year ending March 2010 shows that prices rose 9.9%, though high but less than market expectations. Interestingly, while the food inflation appears to be on the decline, manufacturing prices look set to rise on the back of a strongly rebounding economy.

The increase in non-food or core inflation has been cited as a cause for concern and has been invoked to justify the calls for raising interest rates. Other indicators of economy growing fast include - rapid increases in various credit ratios, wage growth, corporate earnings and investment demand growth.



However, as the graphic from Mint indicates, the worst of the food inflation may be over and it appears to be on the way down. The good Rabi harvest and start of its inflows into the market will exert a downward pressure on food prices. The WPI inflation index too appears to have stabilized for the past few months. In fact, any increase in manufacturing inflation due to increase in global oil and commodity prices or other supply side factors cannot be addressed with monetary tightening.

Further, as the Planning Commission member Saumitra Chaudhuri said, some of the increases in prices are due to the low base effect of last year when economic growth was considerably repressed. The Planning Commission too does not believe that the inflation for 2010-11 will exceed 4-5%, especially in view of the weak economic conditions in much of developed world for the foreseeable future. Therefore, despite the leading indicators pointing to a recovery, the case for aggressive monetary tightening is not very clear.

In this context, is the 4-5% inflation being targeted for countries like India a little too contractionary? This assumes significance in light of the recent suggestion by the IMF, in a radical break from its traditional position, that developed economies raise their normal inflation targets from 2% to 4%, so as to have adequate room to manouevre with monetary expansion even if the interest rates touch the zero-bound.

Assuming that developed economies have annual growth rates in the range of 3-5%, compared to India's 8-10%, is it not natural that the inflation targets for the developing economies be higher? How much higher will be a matter of some debate. Should we target an inflation rate of 6-7%, especially given the ambitious double digit growth rates being aimed at?

Interestingly, all the developing economies who enjoyed high growth rates for a sustained period, did have similar inflation rates. In fact, such rates were considered acceptable in India itself all through till nineties. The danger with this is the possibility of inflationary expectations getting out of control.

2. Raising interest rates now will also lead to an increase in the interest rate differentials between India and the US, where rates are likely to remain at present level for the foreseeable future. This in turn will only increase the incentives for dollar carry trades, resulting in increased capital inflows into India and putting upward pressure on the rupee. An appreciating rupee will continue to erode the export competitiveness and increase calls for forex market intervention by the RBI.

In a recent Business Standard op-ed, Shankar Acharya expressed concern at the fact that the current account deficit has been in excess of 3% for more than two quarters and this has coincided with exchange rate appreciation and rising inflation.



As he wrote, normally when a country runs a moderately high current account deficit and relatively rapid inflation is weakening its competitiveness, a depreciation of its currency is expected, whereas the opposite seems to be happening with rupee. The large inflows of foreign capital coupled with the RBI's reluctance (or inability to undertake sterilization of the foreign currency purchases given its preoccupation with managing the record borrowing programme of the government in 2009-10) to intervene in the forex market have contributed to this contrarian trend.

He also points to the adverse impact of Chinese currency manipulation, by pegging its renminbi with a declining dollar, on our exports. In the circumstances, in order to prevent rupee from appreciating and amplifying the external account imbalance, he advocates that the RBI undertake foreign currency purchases (with required sterilization, either through open market sales of government bonds or a resurrection of the market stabilisation scheme or an increase in the CRR) and/or impose some form of capital controls (reduction of ECB borrowing limits, Tobin taxes, tighten P-Note regulations etc), as advocated again by the IMF recently, to limit the surge in inflows.

However, there are problems with implementing Prof Acharya's prescriptions. One, the appreciating rupee has contributed towards keeping imports cheap and therefore inflation (especially manufacturing, by way of capital equipment imports and oil prices) under control. Therefore a depreciation will surely add to the inflationary pressures. Second, it is also debatable as to whether the RBI can afford to intervene aggressively enough (especially when it also has to meet the government's massive borrowing obligations) to keep the rupee from appreciating since it would lead to build up of reserves (which will then stay invested with low return yielding dollar assets) and increased cost of servicing the sterilization efforts.

In this context, as mentioned earlier, raising interest rates will only widen the rate differentials and encourage carry-trade opportunities and capital inflows, and thereby appreciate the rupee further. Also, the higher rates also means that the cost of sterilization interventions increase and thereby constrain the RBI in its market interventions.

The difficulty of managing such situations also highlights the need to deploy a careful mix of all available options, without relying exclusively on the conventional interest rate channel. I have already blogged about how the RBI used multiple instruments to manage the macroeconomic environment effectively and largely avoided the adverse impact of the sub-prime crisis.

See also this excellent op-ed in the Businessline by Kanagasabapathy who suggest that apart from working on aligning its repo, reverse repo and bank rates, the RBI should also move from being a passive absorber of funds (through its LAF window) to more active liquidity management (by buying g-secs and repo operations to keep call money rates in the repo-reverse repo band). This will ensure that the markets respond immediately to policy interest rate changes (by integrating the rate and quantity channels) so that the ‘rate channel' transmission of monetary policy becomes more effective. As he writes, the rate and quantum channels can be integrated and monetary transmission made effective only if the policy rate changes are complemented and supported by active liquidity management operations.