Consistency may generally be regarded as the virtue of fools, but consistency is the least one expects from a central bank. Having joined the battle against inflation, and finding the enemy still unvanquished, the Reserve Bank of India (RBI) had no option but to take the rate hike action that it did last week: it increased the repo rate by 25 basis points, taking it to 8.25 per cent. If the spectre of inflationary expectations continues to haunt, one must expect RBI to take further action, at least till it reaches the pre-Lehman threshold of nine per cent. In that sense, the central bank still has some headroom for further action. That this has negative consequences for growth and capital formation is well understood by policy makers and it is clearly the price the central bank thinks the economy ought to be willing to pay for price stability as well as for altering the state of expectations. Even the critics of RBI’s monetary policy would have to concede that the instruments of monetary policy are the only armoury at the apex bank’s disposal, and as long as everyone expects the central bank to fight inflation, it is bound to use the only ammunition in hand.
A consequence of sustained monetary policy action, and belated fiscal policy action, would be a slowdown in growth. But that is the price India’s macroeconomic and political authorities must perforce pay since persistent inflation is more destabilising than a slowdown in growth. At any rate, the expected rate of growth is now in the vicinity of 7.5 per cent, not bad by both India’s own standards and current global standards. If the battle against inflation is won, and inflationary expectations can be anchored at sub-six per cent level, growth will recover in time and would be based on more stable macroeconomic foundations. It is now clear that the sustainable rate of growth of the Indian economy, at existing levels of savings and investment, factor productivity and sustainable fiscal and current account deficits, is in the neighbourhood of eight to 8.5 per cent, rather than the nine to 10 per cent range. If overall macroeconomic and governance conditions at home and abroad improve, then the growth rate could be pushed closer to nine per cent, the growth target for the 12th Five-Year Plan period (2012-17).
The RBI’s review correctly draws attention to the fact that despite a normal monsoon food price inflation has not eased, nor has India fully absorbed the impact of high global commodity and energy prices. However, on this front too, the future holds the prospect of some easing of current pressures. All in all, the chances of improvement in the next quarter, despite fears of “double-dip recession” in the transatlantic economies, remain high. This means it is an appropriate time to adopt a more cautionary stance on inflation. If things worsen globally and at home, RBI would have the legroom to ease rates. Without using up the headroom available, there would have been no space for any legroom in the future, so to speak!
Finally, a word of advice for all other economic policy makers in New Delhi. Keep your counsel on inflationary expectations to yourself unless you are sure about what you are saying. Much like the rumours about Mark Twain’s death, official forecasts about the death of inflation have been vastly exaggerated, to say the least, and have hurt the credibility of macroeconomic authorities. While battling inflationary expectations, hurtful action is better than harmless talk.