Policy without framework

RBI Governor Y.V. Reddy will announce the credit policy for the next quarter on July 31. The event is unfortunately marked by great uncertainty. The last few months saw a sharp increase in EMIs and a sudden appreciation of the exchange rate that left lakhs of firms and households rattled. The credit policy announcements of RBI officials had not prepared them for what was going to hit them. Business plans went awry. Household budgets were shaken. The July credit policy needs to do a better job than the last one. It needs to give a clear signal about the RBI's thought process. But first, the RBI needs to get back its control over the short term interest rate.

Many people are hoping that interest rates will be reduced in the upcoming policy. One rationale for cutting interest rates is that inflation has come down. Interest rates were raised on the logic that the inflation rate was high, the economy was overheating and India desires an inflation rate below 5 per cent. Now the inflation rate based on the wholesale price index has been consistently below 5 per cent for many weeks. Further, the RBI was concerned that bank credit growth was too high. It had been above 30 per cent for nearly 3 years. Growth in bank credit has now come down. In June 2007 it was 24.6 per cent compared to 31.0 per cent in June 2006. Further, higher interest rates in India are attracting capital inflows. Companies borrow abroad cheaper in dollars or yen adding to the RBI's problems as it puts pressure on the rupee to appreciate. Given these developments, would the RBI ease up a little?

Cutting interest rates would involve changing the policy rate. Central banks usually operate with one policy rate. The US Federal Reserve Bank, for instance, works with the Fed rate. This is currently at 5.25 per cent. Similarly, the Bank of England has a single policy rate which is the short-term rate. Changing interest rates is simply a matter of announcing a change in the policy rate.

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