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Rate hikes effected so far will not dent growth significantly

After an extended period of belt tightening, minders of India’s monetary policy at the Reserve Bank of India shifted to a somewhat softer stance at the start of 2013 in the wake of falling inflation numbers and weakening growth prospects.

However, before long, RBI was forced to resort to harsher measures to salvage the debilitating rupee with an unanticipated turn for the worse in the global economic scenario, last summer, as word went around that the US Federal Reserve would start tapering its $85 billion-a-month bond-buying programme. However, these measures skirted any changes in the main policy rate that is, the LAF repo rate. As the currency stabilised towards the close of the second quarter, Raghuram Rajan, who had by then taken over the reins at the central bank, implemented steps to temper the money policy, and helped stabilise financial markets.

Yet, the economy remains under a tight interest rate regime, as strong inflationary pressures keep building up. Many economists now believe that the economy has been witnessing stagflation since the second quarter.

Considering that the primary mandate of any central bank is to control inflation, the RBI took upon itself the task of taming rising prices, on account of supply side bottlenecks. No wonder, its moves to hike interest rates and their implications on the economy have been subject of serious debate.

It is commonly understood that persistent inflation hurts all segments of the economy in one form or the other. There are two broad measures of inflation, the WPI and CPI. While WPI inflation has hovered above 7 per cent for most of the past two years, barring March-July 2013, CPI inflation has held steadfastly close to the 10 per cent. High food prices, triggered by increased demand for protein-rich items, have been a constant factor behind rising inflation.

Meanwhile, infrastructure bottlenecks, surging imports and policy paralysis have also stalled near-term growth. It is for the government to address the issues of removing infrastructure bottlenecks to eliminate supply-side constraints, while framing investor-friendly policies.

RBI has been worried that the negative impact of all this, particularly inflation, will hurt even medium-term growth prospects. Naturally there are concerns about how the rate tightening measures will impact both inflation and growth. Supply side issues cannot be sorted out with a tighter interest rate regime that will only hurt growth prospects further.

We believe that the rate hikes effected so far will not dent growth significantly, as they are not coercive enough to restrict aggregate demand through the credit channels. Banks too have signalled that they will not hike rates immediately, taking the RBI’s assurances that interest rates would be moderated once inflation is tamed, and growth gets back on the upward trajectory over the medium term.

Besides inflation, currency volatility also remains a point of concern for RBI. Given the currency turmoil in emerging economies and the Fed’s ongoing tapering of its quantitative easing programme, ensuring currency stability will remain top priority for RBI.

Overall, we expect GDP to grow at 4.8 per cent in FY14 before rising to around 6 per cent in FY15.

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