Opinion is divided on whether the Reserve Bank of India (RBI) did enough on the monetary policy front last week to rein in inflation. Is RBI behind the curve or on the ball? Those who defend RBI believe that its response was along expected lines given the circumstances. These “circumstances” include the massive government borrowing programme (Rs 2,87,000 crore in the first half of 2010-11 itself). Can the central bank afford to shift focus away from inflation and try to balance it with other objectives like lowering the government’s cost of borrowing? This can be gauged by answering another simple, counter-factual question. Would monetary policy rates have been much higher had the government’s draft on funds been significantly lower? If the answer is yes, as the RBI’s critics would argue, then there is a problem. Keeping monetary policy easy to “accommodate” a large fiscal deficit, they point out, is somewhat akin to printing notes to pay for the government’s excesses. This, as history shows, is likely to lead to high inflation in the future. The implication is that if inflation fuelled by surplus cash indeed begins to escalate, RBI will have no option but to go in for a one-off adjustment in rates. This could be disruptive not just for the financial markets but for the economy as well.
Those who are critical of the RBI’s soft touch claim that this potential “shock” to the system (from a large one-off increase in interest rates) can be avoided if the central bank shows tougher love to the fiscal authorities at this stage itself. Thus, if RBI were to fall in step with the curve by tightening monetary policy more aggressively now, the need to catch up later through sharp moves in policy rates will not arise. RBI is by no means alone in its dilemma. Governments across the world, particularly those in advanced OECD economies, have run up large deficits to fight the slowdown, saddling central bankers with the task of ensuring that these deficits don’t push up interest rates too high and poop the recovery. The critics would point out that there is an important difference in the imperative faced by RBI and its counterparts in the developed world. The latter have to contend with the problem of a fragile economic recovery that threatens to reverse at the first sign of trouble. The pick-up in India’s economy seems far more robust and entrenched — hence inflation should get policy priority. However, while the jury could still be out on how quickly RBI should reverse its stance, there is consensus on the fact that the perception that RBI takes orders from the fiscal mandarins will seriously compromise the central bank’s credibility and set financial reforms back by a couple of decades. Some see the central bank being divested of the job of managing public debt as an option. This too cannot work unless an office for the purpose is truly independent of the finance ministry.