Everybody’s got a stake in it, and,naturally, everyone’s got an opinion on it. That’s why the past few months have seen policy wonks in the Finance Ministry, the Planning Commission and the Reserve Bank of India (RBI), to name a few, holding forth on the wisdom, or lack of it, in raising interest rates. Well, by the time you read this story, it will be clear which school of thought has prevailed—the RBI’s monetary policy review meet on October 27 will ensure that.

Whatever decision the RBI makes would have been dictated by both immediate and future considerations. Three overriding factors would have influenced that decision: the need to ensure continued growth, the need to counter inflation, and the possible fallout of any upward revision in interest rates.

The Growth Factor

If there’s one thing that both the government and the RBI agree on, it’s on the need to ensure continued economic growth. When the global economic crisis began, following the events of September 2008, the crisis threatened to overwhelm the Indian economy. There was a sense of panic as companies either postponed or cancelled their investment plans, consumers cut back on spends, and exporters saw shipments plummeting sharply. To stem this tide, the RBI, working in concert with the Finance Ministry, cut interest rates and injected a high level of liquidity into the system. It reduced the repo rate—the rate at which it lends to commercial banks—from 9% to 4.75%. The cash reserve ratio (CRR, or the quantum of cash banks are required to maintain with the RBI) was also cut from 9% to 5%.

Those measures, in combination with lowering of tax duties and extension of sops by the government, ensured the economy slowed down marginally and not dramatically. Today, it is recovering—in August, industry grew at its fastest pace in more than 20 months. Industrial output expanded 10.4% as compared to 1.7% during the same period last year.

The Purchasing Managers’ Index (PMI) stood at 55 (a reading above 50 indicates expansion) and two-wheeler sales increased by more than 20% during the month.

The improvement has made the RBI consider raising rates again. However, the central bank also has to ensure that it doesn’t nip the recovery in the bud. That may require it to maintain current interest rates or, at most, make only a slight increase—something the government would accept. Finance Minister Pranab Mukherjee has stated that the RBI ought to strike a balance between growth on the one hand and inflation concerns on the other.

The RBI Governor recently said that India, as it was growing well, may need to exit from the accomodative monetary policy before advanced economies.

On his part, Planning Commission Deputy Chairman Montek Singh Ahluwalia has been a vociferous champion of maintaining the liberal regime. “There’s no case for doing anything other than continuing with the stimulus. It would be a mistake to think that the economy has recovered,” he said recently, while speaking to reporters. Ahluwalia is of the opinion that the accommodative policy should end only when growth crosses the 7% mark.

But RBI Governor D Subbarao has a different point of view—the mirror opposite, in fact. Compared to negative growth in developed economies like the US and the UK, he believes the Indian economy is in good shape—the RBI expects the Indian economy to grow at 6% in the current fiscal. That led the Governor, who was attending an international banking seminar in Istanbul, to say: “Unlike the major advanced economies, growth remains positive. In view of the country-specific features, we may need to exit from the accommodative monetary policy earlier than the advanced economies.”

The Fear Of Inflation

Inflation is the primary reason the RBI want to roll back interest rates. On paper, a liberal interest-rate regime is the best thing for an economy. It ensures a high level of liquidity, borrowing becomes cheap, hiring increases, growth gets a shot in the arm, and government revenues are robust. Everybody has money in the pocket and everybody comes out ahead. And that’s why everybody wants the liberal interest-rate regime to continue.

But there’s a flip side. A relaxed policy will fuel inflation and expectations of inflation (how people see prices behaving in the future). This can dampen growth—for instance, workers would demand higher wages, pushing up the cost of production. In turn, this would increase the prices of various goods, resulting in a fall in demand. Moreover, the government too would have to pay more to borrow money from the market—because those investing in bonds would want higher yields to guard against higher prices. A conservative monetary policy would, however, go some way to address the problem of inflation.

If food inflation is the issue, then monetary policy is not the tool of choice to address it.Ajay Shah, Senior Fellow, National Institute for Public Finance & Policy

Food Inflation Worries

Most economists expect inflation to rise from the current 1% to 6% by March next year. This is primarily due to the ‘base effect’ (as commodity prices slumped after September 2008) and higher food prices. With the southwest monsoon showing a deficit of 22.7% so far, the kharif (or summer crop) will be affected. But the rabi (or winter crop) is expected to be normal. Despite this, agricultural output is expected to shrink by 2% this financial year. Mukherjee has said rice production alone could be 16 million tonnes lower this year because of the twin impact of the drought and floods.

Lower farm output is expected to put upward pressure on food prices. But experts say there is no evidence that it’s spreading to the non-farm sector. “I don’t see any pick-up in inflation at this stage. It’s better for the RBI to wait for two or three months before taking a call on reversing its policy,” says Pronab Sen, India’s Chief Statistician and Secretary in the Ministry of Statistics and Programme Implementation.

The latest inflation numbers support Sen’s view. While overall inflation measured by the Wholesale Price Index (WPI) increased 5.95% from March this year, prices of manufactured products, which constitute nearly two-thirds of the WPI, increased only 3.68%. Primary products (which capture farm output) went up sharply by 9.84%. Prices of food items, in particular, have risen by as much as 14.13%.

An increase in interest rates would lead to huge international capital inflows, and problems.Arvind Subramanian, Senior Fellow, Peterson Institute for Int’l Economics

“If food inflation is the issue, then monetary policy is not the tool of choice,” says Ajay Shah, senior fellow with the National Institute for Public Finance and Policy. “Monetary policy matters over the medium term, by which time the next monsoon will have come and gone.” The right strategy, according to him, is to cut import duties and flood the market.

The RBI’s comfort zone for overall inflation is around 5%, and it wants to act before the rate threatens to cross that zone. To do so, it can choose to increase interest rates, such as the repo rate, or hike the CRR, or both. This would suck a portion of liquidity from the market.

But, just as the relaxed norms ensured the economy continued to grow while the world economy suffered, a tightening of rates could bring India’s economic recovery to a grinding halt. And that’s why an overwhelming majority of economists are against any move to increase interest rates or reduce liquidity to control inflation.

Potential Negative Impact

Again, an increase in interest rates now could prove counter-productive for a number of reasons. For starters, developed economies like the US and UK are unlikely to increase their short-term policy rates. Given this, says Arvind Subramanian, senior fellow with the Peterson Institute for International Economics: “If the RBI raises rates, it would lead to huge international capital inflows into the country and that would create a problem.”

Any inflows would increase money supply and would actually lead to a spike in inflation. Thus, a rate hike would be counter-productive. “The ideal strategy is to keep interest rates and liquidity steady and watch out for some evidence of non-food inflation picking up,” he says.

Another effect of international capital inflows would be the appreciation of the Indian rupee, making exporters less competitive in the international markets, more so at a time when exports have declined 30% in the last six months.

Again, the RBI and the government are both keen on reviving private investment. That segment could be affected adversely if interest rates go up or liquidity is reduced. Already, with inflation at record lows in the last five months, the real cost of borrowing (the nominal interest rate minus the inflation rate) has increased at a time when demand, especially export demand, is sluggish. Revival of private investment is critical as it contributed to more than half of the 9%-plus growth in the economy during the three years ending March 2008.

Some believe the RBI should fix the banking system first. Despite the 4.25 percentage point cut in the repo rate, the average lending rate of commercial banks declined only 1.2 percentage points, from 12.3% in March 2008 to 11.1% in March 2009, says an RBI report. “The structural downward inflexibility should be corrected and the RBI needs to re-think on the structure of the banking system,” says Subramanian.

Clearly, the pros of maintaining the current interest-rate regime outweigh the cons. That perhaps explains the great divide, with the RBI, advocating moderation, on one side, and all the other voices, wanting the status quo to continue, on the other.

It’s not as if the folks sitting in the RBI are blind to the benefits of a liberal monetary policy. They are, after all, among the best banking brains in the country. So, why this contrarian stand? The answer may lie in the statutory objectives enshrined in the RBI charter. One of those objectives directs the bank to “maintain price stability”. It is, in a sense, the body entrusted with the job of reining in inflation. Again, as the government’s banker, it has to ensure that government borrowings, which are huge, are not made at a heavy cost. So, formulating monetary policy will always be a tough balancing act for the men and women who run India’s central bank.