In the past couple of years, the Reserve Bank of India (RBI) has enjoyed goodwill among a wide range of stakeholders and policy makers at home and abroad for two important reasons. First, for the maturity and quiet confidence it showed, under the able leadership of Governor Duvvuri Subbarao, in responding to the post-Lehman situation in global financial markets. And second, for its refusal to fall prey to the fashion of the day in policy matters, especially in the lead-up to the crisis, and for insulating India from some of the sharp business practices of trans-Atlantic banking and financial institutions. Riding on this mix of popularity and credibility, the RBI has been able to slowly roll back the policy stimulus provided in response to the economic slowdown.
However, after the March monetary policy statement, it would appear as if the central bank’s inflation-fighting strategy seems to be going wrong. Despite three upward revisions over the course of the year, its forecasts for 2010-11 year-end inflation have proved to be much lower than the actual data print. The March inflation rate turned out to be 9 per cent compared to the RBI’s prediction of 8 per cent. To be fair, most analysts shared the RBI’s rather sanguine view of inflation in the run-up to the March statement. Even this newspaper editorially called for a breather from rate increases. It appears now that if one extrapolates the revisions in the data that have been announced in the past months (these are available till January), the March inflation number could well be in double digits. There is a twist to this tale. “Core” inflation, roughly measured as the price increase in a basket of goods excluding food and fuel, has begun to perk up since December. This suggests that inflation cannot entirely be explained away by local and global supply deficiencies that have pushed food and fuel prices up. High core inflation suggests that domestic demand pressures are also building up for a broader range of goods and inflation is stubbornly embedding itself in the economy.
Fighting inflation is a basic dharma of a central bank, and many now believe that the RBI has “fallen behind the curve” in the cycle of rate increases and should act more aggressively going forward. There could be some truth in this. The RBI should explore the option of deviating from its path of calibrated rate hikes and raise policy rates by half a percentage point instead of a quarter in the annual monetary policy due on May 3. Besides, empirical evidence points to the fact that core inflation is much more responsive to monetary action than supply-driven inflation. This should buttress the case for a sharper rate increase. However, while an aggressive hike could assuage some of the anxiety that policy response to the price spiral has been inadequate, it is unlikely to be the silver bullet that pulls down inflation sharply.
The current price situation stems from a concatenation of diverse factors. There is a structural dimension to it driven by the long-term neglect of agriculture and the consequent absence of a supply chain for things like vegetables, poultry and meat. Incidentally, these are items that have seen a secular rise in prices over the last two years. Coupled with this are major structural changes in the rural and informal labour markets that have ramped up wages. High global commodity prices spurred on by lashings of liquidity created by Western central banks are not helping matters either. Moreover, India has delayed adjusting domestic fuel prices to international crude prices which are now in triple digits. The much-delayed adjustment will further drive inflation up. Thus, it is possible to argue that unless some of these issues get resolved, we might just be stuck in what is being described as a “new normal”. Inflation rates could, at least for a while, remain higher than the RBI’s historical tolerance limit of 5 per cent. The RBI perhaps needs to prepare the markets and industry for this.
Industry voices are already opposing any rate increase this summer on the plea that industrial growth has been tardy and company bottomlines are under pressure. There is a fear that the RBI will “capitulate” to the dark forces of inflation and spook the markets and business. These fears might be a trifle unfounded. A clear acknowledgment of the hard reality of the current macro situation and its ramifications for inflation will tend to do a lot more in restoring the RBI’s credibility than another set of optimistic forecasts that are likely to go wrong. The idea of the “new normal”, which includes lower expectations about growth, would also guard against the risk of an overzealous drive against inflation that could potentially hurt investments and compromise the supply side of the economy by pushing borrowing costs to stratospheric levels. Reckless monetary policy could damage capacity creation in the economy and could breed new supply shortages that would abet rather than smother inflation. The central bank should be careful not to create new problems for itself in its bid to tackle its current problems.
The importance of the RBI taking difficult and unpopular decisions, and reinforcing its credibility as an institution of macroeconomic policy making, has increased with economic policy making in Delhi becoming directionless. In the very first quarter of the new fiscal, the budgetary arithmetic of the Union finance ministry has become suspect and few take the ministry’s reassurances seriously. A series of decisions, moves, statements and action/inaction on various fronts on the part of the Union finance ministry is raising new questions about the ministry’s ability to deal with extant macroeconomic and policy reform challenges and about its priorities and prejudices. Given its pre-occupations with the here and now, New Delhi is not paying enough attention to the hereafter.
It is now increasingly clear, as the discussions at last week’s meetings of the Planning Commission revealed, that this year’s growth estimate may have to be brought down from 9 per cent to 8 per cent, and the medium-term projection is likely to be a 9 per cent rate of growth, with a downward bias. Rather than the 9:5 combination (9 per cent growth with 5 per cent inflation) that Finance Minister Pranab Mukherjee posited for the current fiscal, an 8:6 combination seems more likely. The RBI must act to prevent a 8:7 or even 8:8 balance.
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In any case, the RBI need not worry about the spurious “growth vs inflation” trade-off being posited by the finance ministry. Indeed, low inflation is a pre-condition for sustainable growth in a democracy, and higher inflation would hurt growth. Moreover, the policy action required to deal with any “growth vs inflation” trade-off is to bring the government’s fiscal deficit down and improve the productivity of public expenditure. Both are challenges for the ministry of finance, not the central bank.
Given the context, it is incumbent upon the central bank, and Governor Subbarao, to act with foresight, without fear or favour, with grit and determination, resisting any urge to be popular and populist and seeking to bolster the RBI’s credibility.