In his public pronouncements in recent weeks, Reserve Bank of India (RBI) Governor Duvvuri Subba Rao has started sounding a note of caution on inflation amidst news of a better-than-expected recovery in the real economy. He has indicated that India may need to reverse the current expansionary stance sooner than other major economies. To be sure, he has not suggested that this would have to happen this month. There are some expectations that a change in policy stance may be further encouraged by the strong showing in the industrial sector. Apart from an increase in the index of wholesale prices, consumer price inflation has been inordinately high for several months now, mainly on account of the persistent rise in food prices. However, despite these concerns, there are several arguments in favour of maintaining the status quo. Two key factors that the Central bank would be well aware of: first, the inflationary pressure that is visible is almost entirely due to food and oil prices, the latter in particular coming off their very low levels of a year ago; second, the recovery itself, while looking reasonably robust, is still rather skewed towards some sectors and seems to be driven, directly and indirectly, by government spending.
The current wisdom is that central banks should respond to supply-side (or cost-push) inflationary pressures when there is a risk of these spilling over into more broad-based price increases. This can happen when production capacities are stretched and labour markets are tight, as was clearly the case in late 2007-early 2008. This is not the case now. With underutilised capacity and relatively slack conditions on the employment front, the risk of an inflationary spiral is not very significant for the time being. Growth in credit flows remains rather modest, suggesting that private spending is yet to gain the momentum necessary to accelerate growth. Tighter liquidity conditions and higher interest rates could further constrain it. These considerations make a strong case for not raising the benchmark repo rate, which nobody is expecting will happen anyway. But, there are apparently some expectations of a hike in the cash reserve ratio, even if only to concretely signal a change in stance. The problem with doing that now is that banks will simply switch from holding government securities to cash to meet the new requirement. This will drive up government as well as private borrowing costs, serving nobody’s interest.
Of course, the status quo may be the best course of action next week, but is unlikely to remain so for very long. As the recovery gains momentum, demand for credit will accelerate even as government borrowing requirements moderate. Capital inflows will also increase, putting upward pressure on liquidity and exchange rates. A distinctly different macroeconomic configuration will emerge over the next quarter, which will almost certainly require a response from the Central bank on a variety of fronts. But, for now that can wait.
