Expect RBI to raise policy rates soon: IGIDR

Q: Where do you think nominal interest rates could go? Are you expecting several doses of repo rate hike? At 8.5%, would you say that the overnight curve would start at maybe 9% or 9.5%? For 2008, where do you think RBI might stop at?

A: We are in a new sort of world, where there are new options available. Markets anticipate central bank’s action and take signals. The central bank doesn’t have to make a very large change. I do not see a 1% or 0.5% change. They have already raised repo rates by 0.5%. So, the market should pick the signal of short-term nominal rates to rise and factor the same into real rates.

The policymakers will hold off from a sharp rise in rates. In the past when we have seen a sudden response to such a shock, it had a very high output cost, because we are at a precarious level in terms of growth.

Q: What kind of rate hike will you factor in? What is the impact on growth that you are seeing going forward for this year, next, and subsequent years? Are we going to systematically skid away from the 8.5-9% trajectory and go into a 6-7% trajectory for the next three-years?

A: We should give the markets some credit. Markets don’t think this inflation is going to last that long, since liquid long-term rates haven’t risen that much. As long as investment rates remain high, growth is driven more by these long-term determinants. We are fortunate that agriculture has done well this year.

For the first inflationary round to be passed on in the Indian economy, what happens to food prices is very important, because that depends on wages rise and so on. We are very lucky that agriculture is doing well. The government has had some systematic kind of measures, which may show up and improve agricultural performance. Indian growth is somewhat robust, because it is driven by a number of factors. When industry or exports don’t do so well, agriculture does better. So, some elements of domestic demand compensate. We are having a series of repeated shocks.

Q: Are you therefore saying that you do not see a serious skid off from 8% levels?

A: We could do 8% this year, which would be the higher end.

Q: What about subsequent years because interest rates normally strike with a lag in countries like ours, which do not have very healthy or robust bond markets? The expectation is that it will start impacting FY010 growth, corporate performance, and demand growth. Do you see the pain getting worse? Would you say that 8% could more or less be maintained with maybe one year of things going a miss?

A: We are at a point where large amount of infrastructure investment is required. It’s critical that this investment doesn’t slack off. Real interest rates, which are a matter for investment decisions, are very low. Creditors gain when inflation is high, because what they have to repay in real-terms is much lower. So, there is nominal interest rate effect for bondholders and so on. High inflation actually helps those who are borrowing long-term. There is a need for infrastructure investment. We should see investment continuing and that should keep India’s growth somewhat robust.

Q: Your own estimate would be that perhaps 8% will be managed this year. We shouldn’t do too much below 8% in FY010 too?