Through its monetary policy statement and the consequent policy action, the Reserve Bank of India (RBI) has sought to redefine the parameters for macroeconomic policy this fiscal. Instead of trimming its sails and going with the flow, the central bank has charted a new course and expects the government to follow suit. The RBI is right to assert that high inflation is inimical to sustained growth and that current inflation and expectations pose a significant risk to future growth. In opting to lower its growth expectation, in order to bring down inflationary expectations, the RBI has queered the pitch for mid-term fiscal correction by the Union finance ministry. India’s economic growth forecast for fiscal 2011-12 has been adjusted downwards to a range of 7.5 to 8.5 per cent and monetary policy action is based on the premise that unless inflationary expectations are fundamentally altered and the rate of inflation is anchored in shallower monetary waters, the medium-term growth outlook would, in fact, be worse than the short-term deceleration of growth that is now expected. Rather than the growth-inflation ratio of 9:5 underlying this year’s budgetary calculations, the RBI has now posited a ratio of 8:6 with a downward bias on growth and an upward bias on inflation. Hence, the 50 basis point (bp) increase in key policy rates.
If the RBI’s monetary policy strategy has to succeed, it will need supportive policy action from the finance ministry in terms of a paring down of subsidies and other spending targets. While the finance minister has his fiscal task cut out, industry must also do its bit to ensure that cost-push inflation does not add to the pressure of demand-pull inflation. The RBI expects a weakening of pricing power and hopes this will break the wage-price spiral. The spanner in the works would be exogenous factors like a further firming-up of oil prices or a bad monsoon. It is precisely because neither the central bank nor the government has any control on such exogenous factors that the RBI has obviously decided to act purposefully at least in respect of the one variable it controls, namely the policy rate.
The May policy statement is significant because it has also reset the parameters of monetary policy with a new operating procedure that includes a new overnight call money rate, an innovation called marginal standing facility and a new fixed relationship between the repo and reverse repo rates, with the former defined as the single policy rate to which all other rates have to adjust in a predictable manner. The move towards a single rate regime, recommended by an expert committee, will help reduce volatility in money markets and improve transmission of policy signals. Finally, the RBI has done its bit for middle-class India by raising the savings deposit rate by 50 bps, while keeping the issue of deregulation of savings rate open for future action. All in all, Governor Subbarao’s policy statement this week marks a turning point in macroeconomic policy-making, whose impact – positive or negative – will be felt only in months to come.