Indian Interest Rates Have Overshot 26. August 2011 Rahul indian economy (0) Reserve Bank of India (RBI) governor Subbarao’s decision to hike short term interest rates by 50 basis points on July 26th was a mistake. Monetary policy operates with a lag. Many of the earlier interest rate hikes are yet to filter through to economy. The RBI is trying to fight inflation by raising rates and squeezing out demand. In the absence of fiscal policy action, the burden of inflation management falls on the RBI. The RBI is, however, fighting a lost battle. Interest rate increases are unlikely to be effective in controlling inflation and may in fact exacerbate the situation by choking investment and supply. India is not one but multiple economies within one. The starkest difference is between two segments at opposite ends of the spectrum. One is the credit based urban India and the other is the mostly cash based rural India. Urban India is choking, crying and gasping for help, but the RBI remains unrelenting in its crusade against inflation. The numbers have finally started catching up. Housing sales have plummeted and the real estate sector is in intensive care. Automobile sales have started declining. Power and infrastructure investment has come to a standstill. Loan delinquencies among small and medium businesses are rising at an alarming rate. Rural India on the other hand is booming. Food prices have risen and remained high across three full crop cycles for the first time in decades. The rural employment guarantee scheme has ignited a fire under rural wages. The monsoon rains have been excellent and India is on track for a record agricultural harvest. Telecom connectivity has had a transformational effect on rural India. The demographic boom in rural India has created a positive consumption cycle that has been unprecedented. This explains why sales of motorcycles and tractors are booming while sales of passenger cars are declining. For further validation of this trend, look at the ongoing anti-corruption movement being championed by social activist Anna Hazare. It is exclusively an urban Indian middle-class driven movement. Rural India is conspicuous by its complete absence and disinterest in the movement. Urban middle-class India is stuck and frustrated, while rural India has never had it better (albeit from a very low base). In times past, protests and agitations were primarily rural centric while urban inhabitants went about their lives. Food is becoming expensive in Indian cities because a lot less is making it to them. A lot more food is being consumed in villages where it is being produced. For food availability to improve a lot of investment needs to take place in farming as well as in the distribution supply chain. High interest rates and policy inaction are not helping the cause. How India measures inflation is completely flawed. India’s headline wholesale price index is primarily a commodity index. In a zero interest rate world where all currencies are debasing, commodity price increases are an international phenomenon. Indians are putting a record amount of their savings into fixed income instruments and bank deposits. They clearly don’t see fixed income instruments giving them negative real yields. I don’t believe that this phenomenon can be explained by money illusion alone. The fact of the matter is that we are in a world where relative prices shift suddenly and intensively. Most people recognize this and (rightly so) don’t think of it as inflation or erosion in purchasing power. In India there is no homogenous consumption basket and everyone’s effective rate of inflation is different. I believe that, inflation, the way the Indian government measures it, will remain high and may even accelerate from here as debasement in the developed world kicks off in earnest. Raising interest rates to rein in this inflation will prove completely ineffective. GDP growth in India in April-June will print below 8% and it is very likely that by the Oct-Dec quarter GDP growth will fall below 7%. The RBI needs to stop its interest rate increase cycle and start preparing for reducing interest rates lest it wreck the economy.