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Inflation may trigger tighter monetary policy
Published on 25 Jan. 2010 12:27 AM IST
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The credit policy review is around the corner. This time, the Reserve Bank of India (RBI) has a pretty tough task of managing growth and liquidity. The Reserve Bank of India (RBI) would need to balance these compelling forces. According to some bankers, an interest rate increase may be around the corner. Some tough monetary measures by the RBI may be on the anvil in order to rope in the growing inflation rate. Some weeks ago, expressing concern over the excess liquidity in the system , the prime minister’s economic advisory council chairman, Dr C Rangarajan had indicated the RBI may have to increase the cash reserve ratio (CRR) to tackle the situation. In the current situation of excess liquidity, the main task of the Reserve Bank of India (RBI) would be reduction of liquidity in the system. The main lever that is normally used is a hike in the CRR. The CRR is the cash portion that banks have to park with the Reserve Bank of India (RBI) as a percentage of their deposits. Presently, the CRR is five percent. The repo rate is the rate at which the Reserve Bank of India (RBI) lends cash to banks. It is currently at 4.75 percent . The reverse repo rate is the rate at which the Reserve Bank of India (RBI) borrows from banks, and is now at 3.25 percent. The outlook for interest rates is bearish in the backdrop of the rising inflation rate caused by higher government borrowing and the expectations of a monetary policy tightening by the central bank. Going by the inflation figures, it seems like the RBI will use both its options, CRR and repo rate, to rein it in and draw out liquidity. The acceleration of the wholesale price index (WPI) for December 2009 has been 7.31 percent from a year ago. The movement in interest rates will depend on a number of factors. The higherthan-expected growth numbers have renewed concerns that the RBI may soon initiate measures to mop up surplus liquidity, which left by itself could drive prices of assets and commodities up in a fast-growing economy. Presently, commercial banks have to park five percent of the deposits raised every fortnight as CRR with the RBI. With liquidity remaining in surplus, liquidity tightening measures are likely to precede a rate hike. The surplus cash with banks may prompt the Reserve Bank of India (RBI) to prioritise liquidity management over a rate hike. The Reserve Bank of India (RBI) may tighten measures so as to draw out excess liquidity through a CRR hike and later through rate hikes. Much of it will be driven by the RBI’s concerns on the possibility of an asset price inflation. The RBI could increase interest rates or reduce liquidity by acting on the CRR. By hiking the CRR, it can reduce liquidity in the banking system. It could follow the CRR hike with an increase in key interest rates. Reduced cash in the system could push up the interest rates. The interest rates - both deposit and lending rates - may feel upward pressures.

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