In August 2003, the wholesale price-based inflation rate shot up to 8.7 per cent. Yet, the Reserve Bank of India refrained from hiking its key rate. The Indian central bank was closely monitoring the situation and waited till its mid-year review of the monetary policy in October to hike the reverse repo rate - the rate at which the RBI sucks out excess liquidity from the financial system - by a quarter percentage point to 4.75 per cent. By that time, the inflation rate came down to about 7 per cent.
Similarly, when the government hiked oil prices in early September 2005, the RBI did not rush for a rate hike to combat the rising inflationary expectations in the aftermath of the hike. In fact, it waited till its mid-year review of the monetary policy in October to effect a quarter percentage point hike in its reverse repo rate to 5.25 per cent.
It's another matter that the inflation rate was relatively low through out the year 2005-06. After rising to 5.9 per cent in April, the inflation rate veered around 4 per cent for most of the year and never crossed 4.6 per cent.
Then, why did the RBI hike its reverse repo and repo rate last week within days of the oil price hike? Why couldn't it wait for its quarterly monetary policy in July, which is just six weeks away? Officially, the decision to hike the key rates was taken "on a review of current macroeconomic and overall monetary conditions".
Prima facie, there were two objectives behind the rate hike: controlling the inflation expectations and protecting the rupee. The inflation rate which was veering around 4.7 per cent in May could cross the 5 per cent level once the impact of the oil price hike is factored in.
The RBI has projected a 5-5.5 per cent range of the inflation rate in 2006-07. Another objective was possibly to protect the local currency from slipping against the greenback. A hike in domestic interest rates normally encourage the players to build assets in local currency and protect it against any speculative attack.
The prompt action of the RBI makes one thing very clear - the tolerance level for a high inflation rate is fast going down. The proactiveness has also something to do with the central bank's inaction in April when it presented its annual monetary policy. After two successive rate hikes in its key policy rates in October last year and January this year, the RBI pressed the pause button in April and instead adopted a sector-specific approach to curb the phenomenal loan growth.
It did raise the provisioning requirement on standard assets in certain categories of loans as well as the risk weight on commercial real estates loans for capital adequacy purpose.
However, the key takeaway from RBI Governor YV Reddy's surprise rate hike last week is the increasing relevance of global developments in the context of domestic monetary policy. "In a situation of generalised tightening of monetary policy, India cannot afford to stay out of step. It is necessary, therefore, to keep in view the dominance of domestic factors as in the past but to assign more weight to global factors than before while formulating the policy stance," Reddy had said while announcing the April monetary policy.
On June 8, he raised the policy rates hours after the European Central Bank hiked its key rate by a quarter percentage point to a three-year high of 2.75 per cent. The central banks of Thailand, Korea, Turkey and South Africa too hiked their key rates around the same time.
The global interest rate scenario during April was somewhat ambiguous unlike the case now. Apart from these banks, Bank of Canada and Reserve Bank of Australia have also hiked their key rates by a quarter percentage point each over the last two months.
The Bank of England which had actually cut its key rate by a quarter percentage point - from 4.75 per cent to 4.5 per cent - over the last one year is now talking about rising inflationary expectations in the United Kingdom. The Bank of Japan has not yet raised its rate (from zero) but reversed its policy of "quantitative easing" and tightened money supply aggressively.
This is the first instance of a rate hike during the Reddy regime outside the policy announcements. Will Reddy do an encore next month when he announces the quarterly review of monetary policy? During his tenure, he has maintained a minimum gap of three months (in October 2005 the reverse repo rate was hiked to 5.25 per cent and was further raised to 5.50 per cent in January this year) between two hikes - if he increases rates in July, this will be the first instance of his hiking rates within six weeks. Much will depend on the movement of the inflation rate and the outcome of the Federal Open Markets Committee - US Fed's policy making body - meeting on June 28-29.
Even if the Fed goes ahead with another quarter percentage point hike, Reddy may prefer to wait and watch till Bank of Japan and Bank of England bite the bullets as another rate hike in quick succession will dent the domestic growth story. Reddy may not like to play the spoilsport.
At the same time, he may not necessarily wait till October - when the mid-year review of the policy is due - to take his call on the interest rate trajectory.