The actions of six central banks on Wednesday indicate that the global monetary cycle is turning. The risks of recession, or at least a significant slowdown in growth, loom large, while the risks of inflation spiralling back up have abated. Apart from direct interventions in asset markets and the financial sector, as many governments have done in the past few weeks, monetary expansion offers both the financial system and the overall economy the best chance of emerging from the current morass. In the coming days, more central banks are likely to follow the same course of action. The Reserve Bank of India (RBI), which so far has taken steps to ease liquidity but not yet cut rates, is scheduled to make its quarterly monetary policy announcement on October 24. Given the state of the global and domestic environment, what should it do?
Domestic inflation is still high, as measured by the wholesale price index. It is more reasonable, but not in the comfort zone if one goes by the consumer price index. Regardless of how it is measured, inflation is on the way down, but it is unlikely to cease being a concern until March 2009. On the growth front, the first quarter GDP numbers showed a drop, but not dramatically so, from the scorching pace of last year. For the second quarter, the July numbers for the Index of Industrial Production were consistent with this impression. The August numbers will be out later today. Looking ahead at the next few months, there is likely to be a demand stimulus from the arrears and higher salaries being paid to government employees as well as the boost provided by a generally good harvest. In a nutshell, the growth risks do not look that large, while the inflation risks are yet to fully abate. The benefits of softening oil and commodity prices will eventually arrive but, for the moment, the anticipated demand stimulus could aggravate inflationary pressures. Under the circumstances, an immediate boost by way of an interest rate cut is not advisable.
On the other hand, there is clearly a tightness of liquidity in the system, to which a significant contributor is the net outflow of foreign capital. A liquidity crisis could well escalate into a solvency problem, so the RBI is justified in infusing liquidity into the system as shortages manifest themselves. Its decision last Monday to cut the cash reserve ratio by 50 basis points, following its enhancement of the liquidity adjustment facility in September, is entirely consistent with this objective. There is, however, one additional measure which will simultaneously serve both the liquidity objective and a fiscal one. Since 2004, the RBI has been issuing bonds under the Market Stabilisation Scheme to sterilise its accumulation of foreign exchange reserves. As the flow of foreign exchange has reversed, this is a good opportunity to buy back these bonds. The purchases will enhance liquidity, while retiring them will save interest expenses. Of course, these measures will be seen as a change in the stance which, depending on conditions, could be formally signalled with a cut in the repo rate in the next quarterly announcement, in January. In sum, domestic conditions call for the RBI to focus for the moment on keeping the system afloat with appropriate liquidity-enhancing measures. A growth stimulus can wait.
