Overriding inflationary fears

Contrary to the expectations of about half of a sample of market participants surveyed yesterday (and to the desires of a large majority of the respondents) Reserve Bank of India (RBI) Governor Y V Reddy decided to maintain the status quo on monetary policy. Neither the benchmark repo rate nor the cash reserve ratio was changed. This newspaper had advocated a cut in rates, based on a combination of domestic and external considerations. The RBI's decision, consequently, should be viewed as a negative development. However, it is important to understand the forces that determined the decision and why those that underpinned the decision ultimately won the day. Three factors were primarily responsible for maintaining the status quo.

First, while the current inflation numbers are well within the comfort zone, the inability of the government to raise petroleum product prices in response to the recent surge in international crude prices has artificially suppressed the inflation rate. The price of the Indian crude import basket increased by almost 33 per cent from the first quarter of 2007-08 until the end of calendar 2007, while there was no change in retail prices of the four key products "" petrol, diesel, kerosene and LPG. Second, while there has been a significant slowdown in the growth of non-food bank credit, from over 30 per cent during the previous year to just above 20 per cent so far in this year, this has not been matched by a corresponding decrease in the growth of money supply. The former pattern clearly reflects the growth moderation in industrial production but the latter increases the threat of inflation accelerating in the coming months. Third, the statement also refers to the liquidity overhang, a combination of the liquidity adjustment facility, the market stabilisation scheme and the cash balances of government, having tripled over the course of 2007, posing yet another inflationary threat. The combined weight of these considerations apparently outweighed the need to simultaneously stimulate domestic demand and exert a stabilising influence over financial markets.

This is all very well, but by postponing the cut to the next announcement, or even beyond, the RBI may well have introduced a timing risk into the macroeconomic environment. Persistent financial instability will very likely reinforce the already decelerating industrial sector by making the investment climate appear more hostile. Come April, and the inflationary situation may well be at the same level, with growth showing signs of further deceleration. At that point, the RBI's stated commitment to maintaining the growth momentum will be put to test. The question on everybody's mind after this announcement will be: how much must the economy slow down before the growth objective overrides the inflation objective? While there is a strong opinion that the status quo now makes an interest rate cut in April inevitable, the emphasis on the inflation threat in this announcement introduces an element of uncertainty about what will be done in April. Shifting gear, on the critical issue of capital inflows and the exchange rate, and the intention to manage capital flows through "appropriate and decisive" policy measures indicate a commitment to containing rupee appreciation, at least to a non-disruptive pace. Some people will breathe a sigh of relief at this; others will foam at the mouth. Not even the RBI can please everyone at the same time!