In its two-monthly monetary policy review on Tuesday, the Reserve Bank of India chose to keep the headline interest rates unchanged, an outcome that was in line with expectations. Thus the repo rate will remain at 6.5 per cent, and the cash reserve ratio or CRR will remain unchanged, too. This is a prudent decision. While there is considerable pressure to support a nascent recovery through lower rates that might help overcome sluggish demand, the RBI under current governor Raghuram Rajan has gone to great lengths to develop credibility as an inflation-fighter, and a cut now would have dented that credibility.
The statement accompanying the monetary policy review highlighted some inflationary threats on the horizon, including that of firming up oil prices - which crossed $50 a barrel recently - and the upcoming implementation of the Seventh Central Pay Commission award. The recent inflation trajectory will not have provided much assurance to the governor, either; it has inched up. While it still remains more than likely that the current target of five per cent consumer price inflation in January 2017 will be met, the up-side risks, as the RBI points out, cannot be ignored. Global factors will be a factor as well. The Chinese economy continues to be shaky, and the tail risks of major turmoil might have helped persuade the RBI to keep its options open. Meanwhile, the United States Federal Reserve Chair Janet Yellen has indicated that interest rate increases are likely as "positive economic forces" have outweighed the adverse factors for the US economy. Last month's jobs report had disappointed expectations, but she has made it clear that too much significance should not be attached to it.
Domestically, too, the possibility that oil prices might breach the Budgeted "safe" amount of $55 a barrel cannot be ruled out. If it does so for any sustained period of time, the Budget's arithmetic will be called into question and the Centre's subsidy bill, and thus the fiscal deficit, will come under pressure. To the Seventh Central Pay Commission award, mentioned already, should be added the non-tax revenue estimates, which are perhaps a little optimistic. Put together, the Centre's fiscal target may be harder to achieve than originally thought. This, too, would mean that there is additional inflationary pressure in the system which has not worked itself out. Thus, the governor had a careful tightrope to walk. Certainly, interest rates are too high to allow for a wholesale revival of private investment and thus of economic growth - as recent GDP figures underlined, gross fixed capital formation is still below high-growth benchmarks. But the risks to inflation are considerable as well. Given that, there can be little argument that the only safe course would be to keep interest rates at their current level, while maintaining an accommodative stance - and watching and waiting. Many things will work themselves out in the short to medium term, such as the Fed's decision, the path of oil prices, and the supply-side boost to inflation-fighting that should accompany a good monsoon.
