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Title of the article India set to raise interest rates again

URL of the article https://www.thenational.ae/business/economy/india-set-to-raise-
interest-rates-again-1.755019
No. of words 746
Date of publication 29 July 2018
Date of commentary written 10 August 2018
Section of syllabus Monetary Policy
India set to raise interest rates

again
Pressure is building on the Reserve Bank of India to act, taking the
benchmark to a two-year high after June’s 25 basis-point rise
India’s central bank is on course to raise interest rates for a second consecutive policy
meeting as it takes more decisive steps to rein in inflation and stem capital outflows.
With inflation running well above the central bank’s medium-term target of 4 per cent -
and the outlook set to worsen as oil prices stay elevated and the currency slides -
pressure is building on the Reserve Bank of India to act. Bond investors are already
taking shelter in shorter-term debt amid concern this could be the start of a tightening
cycle.
“It’s a great time for the RBI to hike rates because people are worried about inflation
and growth numbers are looking good,” said R Sivakumar, head of fixed income at Axis
Asset Management, which oversees about $11.5 billion in assets. “By December, if
growth falls off, then hiking in December or later will get more difficult.”
Bond investors and a majority of economists in separate Bloomberg surveys predict the
RBI will hike by 25 basis points, taking the repurchase rate to 6.5 per cent on August 1.
Many of them are also watching if the monetary policy committee will shift to a hawkish
stance, a move that will spell more pain for bond market.
A rate move will take the benchmark to a two-year high, following June’s 25 bps hike.
Like central banks from Turkey to Indonesia, the RBI has been propelled into action
amid an emerging-market rout triggered by rising US interest rates and a stronger
dollar.
Domestic inflation worries are mounting: the economy is rebounding, government prices
for some food crops have been raised, and fuel costs are increasing.
The yield on benchmark 10-year bonds has surged 45 basis points this year, rising
above 8 per cent in June for the first time in three years. Short-term yields have risen
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more in anticipation of further policy tightening in the near term, with money managers
including Kotak Mahindra Asset Management buying debt maturing in less than five
years.
“The market view is that it won’t be a long rate-hike cycle,” said Arvind Chari, head of
fixed income and alternatives at Quantum Advisors. “If they raise rates by 25 basis
points and keep the stance neutral, markets will be okay. If they change the stance to
tightening, then you’ll see bond yield going up to 8 per cent," he said.
Whether the debt sell-off will continue or not depends on the message from the six-
member MPC headed by governor Urjit Patel.
A rate hike may provide some respite to the rupee, the worst-performing major currency
in Asia this year, which is hovering near an all-time low. Its 7 per cent drop this year has
driven up the cost of India’s imports, especially oil, a bulk of which is bought overseas.
Pipeline pressures indicate inflation would remain under pressure. Data showed
wholesale prices quickened to 5.77 per cent in June, the highest since December 2013,
while consumer prices rose 5 per cent and core quickened to 6.5 per cent.
While headline inflation could ease in July, Prime Minister Narendra Modi’s offer of
higher crop support prices for farmers may spur the RBI to tweak its second-half
inflation forecasts.
“We expect headline inflation to moderate temporarily in July, before rising toward the 6
per cent mark later this year driven by higher food inflation,” economists at Goldman
Sachs led by Nupur Gupta wrote in a recent note. “We recently added two more 25
basis points rate hikes to our forecasts for 2019, and now expect the RBI to hike
cumulatively by 100 basis points between now and the end of 2019.”
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IA Commentary:
The article reports that Reserve Bank of India (RBI), the central bank of India, is set on
increasing the repurchase rate by 25 basis points on August 1 st to tackle inflation. Repurchase
rate affects the rate of borrowing for commercial banks, which affects overall interest rate.
Inflation is the sustained increase in average price level of an economy i and can be tackled
through increasing interest rate (part of contractionary monetary policy).
The article shows more emphasis on the increase in price of fuel and other imports (due to
worsening domestic currency) as well as government price of food crops˗ this suggests an
increase in cost rather than demand. This is a sign of cost-push inflation ii. As seen in Fig.1, short-
run aggregate supply shifts to the left from SRAS 1 to SRAS 2, causing the equilibrium to move
along the AD 1 curve from point A to B. Interest rate is then hiked to 6.5%iii which causes
borrowing to be more expensive and lowers investment spending by firms. Consumption
spending also decreases as higher interest rate incentivized households to save more.
Consumption and investment are determinants of aggregate demand, the decrease in AD is
represented by the leftward shift from AD 1 to AD 2, further causing the equilibrium to move from
B to C and hence a fall in price level.
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Increasing interest rate indeed helps reduce price level to keep a more stable rate of inflation
which is one of the main aims of the government. A high level of inflation is undesirable as
inflation will reduce people’s real income which means that standard of living will worsen.
People with lower income will particularly be more vulnerable to inflation as increases in
nominal wage may be lagging behind rise in living cost which worsens the already high income
inequality in Indiaiv. As people are already concerned about inflation, as suggested by the article,
implementing policies to stabilize inflation can reduce the uncertainty in India. Moreover,
change in interest rate is always shared publicly which help, further reduce uncertainty and
allows higher investment spending by firms.
Demand-side policies such as contractionary monetary policy would tackle inflation relatively
quickly compared to supply-side policy which prevents further negative consequences of
inflation. The change in interest rate is incremental and easier to reverse should inflation drops or
economic growth fell too much. Another advantage is that there is comparatively less time-lag in
implementation as Central Bank maintains some autonomy. This is contrast to fiscal policy
where budget plans need to go through various approvals. The shorter time-lag may be valuable
as with delays the problem may have already change and require a different solution.
However, implementing demand-side policy may not be the most suited in this situation. India is
facing cost-push inflation, meaning that the problem lies in the supply. Contractionary monetary
policy further causes real GDP to fall as seen in Fig.2 (from Y 1 to Y 2, and further to Y 3). Inflation
targeting may be successful in maintaining low and stable inflation, but in the long-run, other
important government objectives (e.g. economic growth and low unemployment) may be
hindered. Then again, the article mentioned that economic growth is doing well which means
that a fall in real GDP merely moderates economic growth in an otherwise healthy business
cycle.
The article suggests that India’s root cause of inflation lies with the supply and so a supply side
policy may be more suitable. It will lower the price level and increase real GDP in the long-run.
If India has high government revenue at the moment, they may be able to afford adopting
interventionist policies such as subsidised borrowing for the infant agricultural firms that would
target on increasing food supply or perhaps investment in technologies for alternative source of
energy so that the country would be less reliant on imported oil (concerns mentioned in the
article). Or if government budget is not doing well (though they may temporarily solve this
through borrowing from other nations), they may also adopt market-based supply-side policies
such as privatisation that increases competition or reducing unemployment benefits to increase
working incentives. This way, India will be able to achieve low inflation without hindering
economic growth and achieving low unemployment in the long-run.
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Bibliography
i
Tragakes, Ellie. Economics for the IB Diploma. Cambridge University Press, 2012.
ii
Blink, Jocelyn, and Ian Dorton. Economics: Course Companion. Oxford University Press, 2012.
iii
“RBI Bites the Bullet, Hikes Repo Rate by 25 Bps for Second Time in a Row.” The Economic Times, 1 Aug. 2018,
economictimes.indiatimes.com/markets/stocks/news/rbi-bites-the-bullet-hikes-repo-rate-by-25-bps-for-second-
time-in-a-row/articleshow/65226979.cms.
“Income Inequality in India.” Wikipedia, Wikimedia Foundation, 18 Nov. 2018,

iv
en.wikipedia.org/wiki/Income_inequality_in_India.

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Why is the Reserve Bank of India raising interest rates?

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Title of the article India set to raise interest rates again

India set to raise interest rates

“Income Inequality in India.” Wikipedia, Wikimedia Foundation, 18 Nov. 2018,

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