Column: Shaping the yield curve

Dec 17 2013, 05:02 IST
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SummaryRBI may go for a modest 25 bps hike in repo rates with signals that there would be more if inflation persists

Based on the inflation prints—both CPI and WPI—for November, superimposed on comments by the RBI Governor over the previous month, it seems likely that RBI will increase the repo rate on December 18. There is also little doubt that while most of the surge was confined to selected food items, there are concerns about this spilling over into a more generalised inflation. The channels for a potential wage-price spiral are not difficult to foresee: CPI-inflation-linked dearness allowance increases for public sector employees and pensioners, for instance, adds to a significant transfer of funds, which might be characterised by a higher propensity of consumption, adding to demand.

Many issues have periodically been raised about the efficacy and desirability of using a “blunt instrument” like repo hikes to address what is perceived to largely be a structural problem, constraints in agricultural and labour markets due to logistics, lack of efficient storing and transport, and (more controversially), cartelisation at selected points in the value chain. But, as the Governor recently reiterated, “We can spend a long time debating the sources of this inflation. But ultimately, inflation comes from demand exceeding supply, and it can be curtailed only by bringing both in balance. We need to reduce demand somewhat without having serious adverse effects on investment and supply. This is a balancing act, which requires the Reserve Bank to act firmly so that the economy is disinflating, even while allowing the weak economy more time than one would normally allow for it to reach a comfortable level of inflation.”

How might this balance be operationalised? Two questions are important. First, what are the objectives of tightening monetary policy and what instruments are best suited to achieve these objectives? Second, monetary policy, by nature, is a forward-looking exercise, with long leads required to turn economic activity. How much might RBI need to tighten further? Projecting the growth-inflation dynamics is a very state-contingent exercise in the present context, and getting the signals right over different time horizons is a complex and difficult exercise.

Parsing the Governor’s statement above for the first question, it is clear that firm action demands a signal via interest rate increases, but calibrated so that cost of funds do not unduly increase to choke off a capex-led growth recovery. This indicates a 25 basis points (bps) rate increase instead of a steeper 50 bps or more. What purpose might this serve? The core of the

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