One distinct sign of macroeconomic stability is that the frequency of actions by central banks around the world, including the Reserve Bank of India (RBI), has declined considerably. Towards the end of last year, policy rates and reserve ratios were being slashed almost every few days. Now, the pattern has more or less reverted to its schedule, which in the case of the RBI is a quarterly one. The next scheduled announcement is on July 28.
Recent patterns in data, for example industrial production, suggest that a turnaround, however muted, is visible. Since this is, by all accounts, the consequence of the combined monetary and fiscal stimuli imparted over the past few months, the prudent course of action for the RBI is to maintain the status quo in its reverse repo and repo rates and its cash reserve ratio (CRR). Both rates were cut by 25 basis points each in the April announcement, while the CRR was held steady at 5 per cent. While inflation (as measured by the Wholesale Price Index) is currently negative, a consolidating recovery combined with a hardening of some commodity (including food) prices does presage the return of inflationary pressures down the road, something that monetary policy must anticipate. All in all, the status quo appears to be the best alternative.
The pitch has been queered somewhat by the enormous increase in the fiscal deficit. In recent days, there has been a spreading debate on whether this deficit will be monetised or not. In this newspaper’s view, the most direct indicator of monetisation is net RBI credit to the government. This is going to increase, which means that monetisation is taking place. Whether this will have an adverse impact or not depends on how quickly the private sector will recover in terms of higher spending on consumption and investment. To the extent that these sources of demand are subdued, higher spending by government will help to offset their dampening effect on growth. But higher public spending puts pressure on interest rates, which will be aggravated when private spending begins to increase. Herein lies the risk. Unless the government’s demand for funds is curbed in time, high interest rates could choke off a recovery in private spending. This concern could result in pressure on the RBI to find ways to lower rates beyond the existing levels of accommodation of the deficit. But, all that this will accomplish is to substitute inflation risk for growth risk. In a situation in which the economy is recovering, regardless of whether this is being fuelled by public or private spending, the primary responsibility of the central bank reverts to maintaining price stability. It must, therefore, resist the pressure to further accommodate the deficit by way of higher liquidity or lower rates. The onus is squarely on the government to find ways to narrow the deficit so that it does not stand in the way of a robust recovery in private spending.
