Via the credit policy, the RBI has re-asserted its credentials as an independent inflation fighter, says Abheek Barua
Going by the number of column inches that the pink papers devoted to reporting and analysing last Tuesday’s credit policy, it seems to have been treated as a bit of a ‘non-event’. A reason for the media’s apathy could be that the policy was somewhat predictable and lacked an element of surprise. That is certainly true — most analysts had expected stability in the policy rates and other policy parameters like the cash reserve ratio. That is exactly what the policy delivered. However, its predictability cannot be held against it, nor does it undermine the importance of the policy in the current scheme of things. In fact, I think that it was one of the most important monetary statements that we have seen in the past few years. Let me make my case.
Over the past year or so, fiscal and monetary policy has worked in tandem, fiscal policy taking the lead. This was perhaps desirable, given the need to fight to stave off the recession risk that came on the back of a global slowdown. We were hardly unique in this kind of policy coordination. Finance ministries revved up their spending machines and their central banks committed to ‘funding’ this by supplying more money. In the US, for instance, while the federal government is spending roughly about a trillion dollars in propping up demand, the US monetary authority (or the Fed, as it is commonly known) pumped in roughly $1.75 trillion of cash.
In more normal times economists would frown on this kind of cosy coordination .Over the past three decades, practitioners and theorists have found great virtue in central banks’ retaining their independence and in their refusal to fund fiscal binges by printing notes. Central bankers are expected to have one clear objective — fighting inflation by maintaining an optimal level of interest rates. While this could at times seem to be adverse for short-term growth, economists would argue that economic growth could sustain in the long term only if there is unconditional commitment by the central bank to maintaining a low inflation rate even at the cost of short-term growth.
With the first signs of economic recovery becoming visible, a valid question is: Will central banks operate independently again or has the economic crisis brought about a permanent change in the relationship between the fiscal and monetary policy? Last Tuesday’s credit policy is important in that it provides a clear answer to this question. The RBI has re-asserted its credentials as an independent inflation fighter. Instead of promising to keep the monetary taps on for as long as the fiscal deficit remains large, RBI Governor D Subbarao has categorically stated that he is getting increasingly worried about the prospects of growing price pressure and intends to do something about it.
His advice to the finance ministry is to put together a credible action plan to bring the fiscal deficit down. To quote the policy itself, “The Government will, therefore, need to return to a path of fiscal consolidation. This entails two facets on the way forward. The first is to lay down the roadmap for fiscal consolidation. This has to go beyond merely indicating revised FRBM targets to giving out the details of the adjustment that will take place on the revenue and expenditure fronts. That will lend credibility to the fiscal stance and also give predictability to economic agents.” If fiscal compression is not quick enough and Subbarao refuses to play ball, this could mean a sharp rise in borrowing costs.
Is the RBI fretting unnecessarily about inflation prospects? The credit policy provides enough evidence to defend it ‘hawkishness’. For one, it dismisses the current phase of negative WPI inflation as purely a statistical effect and asserts that “it should not be interpreted as a contraction in demand.” This statistical (or base effect), it points out, is likely to disappear in a few months.
Second, it disaggregates the headline numbers that provide somewhat startling insights. While aggregate wholesale price inflation for the week ended July 11 was (-)1.14 per cent, wholesale price inflation for essential commodities was as high as 10.6 per cent. This was driven, in part, by high food price inflation that printed at 8.25 per cent for the week. Consumer price inflation, which has a large representation of food prices, for June averaged over 10 per cent.
Third, (this is data published in the RBI’s macroeconomic review released last Monday), the central bank shows that while the fall in global commodity prices has been sharp, the drop in domestic prices has been far less pronounced. Take rice prices, for example. Global rice prices were down 24 per cent in June 2009 over the June 2008 level. In India, prices were up by about 15 per cent. Thus transmission of global deflationary trends to India has been incomplete. Local inflation pressures are thus likely to be significantly higher than global pressures.
The implication of all this should be fairly obvious. Inflation is moving up, the central bank seems quite concerned and the government is a fairly large borrower. Thus interest rates are likely to head up over the next few months. How much they will move up will depend on how soft Subbarao’s touch is. I do not expect any major policy move until early 2010. Until then borrowers still have some breathing space as the rise in lending rates will be gentle. However by the middle of 2010, if inflation pressures build up and the fiscal deficit remains high, rates could move up a lot more.
Governor Subbarao became RBI governor at the peak of the global financial crisis. Circumstances forced his hand and he had to take cues from the fiscal managers in New Delhi. There were the inevitable questions of whether his previous assignment as finance secretary would influence his operating style as the head of monetary policy. This credit policy seems like an attempt by Subbarao to assert his independence and prove his inflation-fighting credentials. If he succeeds, that should be a good thing for the economy.
The author is chief economist, HDFC Bank. The views here are personal
