By Anjan Roy
One swallow does not make a summer, the old proverb goes. But even a single swallow can give some hopes for a return to better times.
A softer trend in the wholesale prices, as revealed in the latest figures, had ignited demands for a softer stance in monetary policy of the Reserve Bank of India. RBI has been raising interest rates for more effectively taming the runaway prices for last one year.
The latest wholesale price index (WPI) at 3.85% in February means for the first time in two years it is below the threshold tolerance level of the Reserve Bank. RBI’s tolerance band for inflation is 4% plus/minus 2%. Some experts and commentators are even more optimistic since statistically the index is set to fall into negative zones in March.
The argument is that if the WPI heads southward, the consumer price index should also follow suit at a certain lag. The CPI is currently well above the comfort level of 6%. On Monday, the latest CPI print released by the government stood at 6.44%.
Divergent trends and levels of WPI and CPI are common, though in the long run they should converge. But for the moment these could diverge a lot because the two indices have a different basket of goods as well as different emphasis. WPI has great emphasis on, say, manufactured goods, while the CPI emphasises the food and fuel group of articles. The weightage in calculation thus differ.
For the Reserve Bank, it is the CPI measure which is taken as the relevance indicator of prices. Earlier, the RBI used to take into account the trends in WPI for its monetary policy formulation.
Thus, the lower WPI print is no ground for the RBI to take a re-look into its monetary policy stance. After all, the government has tasked the RBI to primarily ensure a stable price regime. Most central banks across the world have their basic role in maintaining the general prices as inflation was the worst enemy of economic stability and equity.
However, a technically severe approach to monetary policy formulation could sometimes do more harm than good and eventually defeat even its principal objective of maintaining price stability. It can land in a situation when the medicine is worse than the disease. Something of this kind could be suspected to be happening in the United States with its central bank, the Federal Reserve, pursuing a restive monetary policy for one and a half years now.
For sure, the US was facing a rising price line and the inflation rate had touched a four-decade-high middle of last year. Americans, used to low and stable price levels for as long as they could remember, were facing unprecedentedly high prices of common items of daily needs. So a policy of raising interest rates to take off the heat was a normal approach for a central bank.
In the process, however, it was hurting some of its vital sectors. Interest rate is a rather blunt tool to use as a change in interest rate affects all. A rising interest rate might cool down demand for new housing and thus help in bringing down fast moving house prices. But at the same time a sharply rising interest rate regime could deliver a fatal blow to the financial markets and the financial intermediaries.
A steady total 2.35% increase in Federal Reserve’s policy interest rate has created a tumult in the stocks as well as in the bonds markets. Any rise in interest rate results in a loss in bond prices as existing bonds are off-loaded in favour of new higher interest being ones. When marked-to-market, bond holders book losses.
Commercial banks are the primary holders of large stocks of existing bonds. As the US government was borrowing vast sums of money from the market, the banks were picking up these funds to park their surplus funds and also for their treasury operations.
Following persistent hikes in interest rates, banks had lost on their holdings of treasuries. To an extent this is expected and accommodated. Banks provide for their marginal hits just as they earn profits on their treasury operations as well. However, beyond these normal limits, when interest rate policy jacks up the costs of bonds, there is problem on hand.
Two of the US banks have already failed because of the rising interest regime leading to their booking large losses. At least in the case of the Silicon Valley Bank, this seems to have been a contributory factor to its sudden demise, apart from some uncertainties in the technology sector to which it had large exposures.
The second bank, Signature Bank, also faced some difficulties lately and the regulators thought that a orderly process of its liquidation was far more better option than seeking to bail it out. Unknown for now, it is not right now clear how many more US banks might be facing similar losses on account of their bond investments.
In India, the RBI should do well to think about the implications of a steady rising interest rates on banks’ profitability. Here as well banks are a major holder of government securities and they certainly have to mark a portion of their holdings to market.
This apart, the economy is just about recovering from the wretched covid attack. Pursuing a rather one-track approach of inflation control ignoring the requirements of a nursing economy could be counter-productive. The manufacturing sector as also the capital intensive up-stream industrial industries need hand holding for a while.
Why not take these into account while thinking of the next moves on monetary policy in the first few of April when the next meeting of RBI monetary policy committee is due to hold their consultations. (IPA Service)
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