The Reserve Bank of India (RBI) has sent a firm signal that it will stay the course on fighting inflation. While RBI forecasts that the recent surge in headline rates of inflation is set to roll back and prices are expected to moderate, it would like medium-term inflation to return to levels closer to 4-4.5 per cent. However, in effecting only a 25 basis points (bps) increase in repo and reverse repo rates, RBI has sent two messages. First, that it will most likely hike the rates by 25 bps every quarter through the financial year. Second, that there is only that much monetary policy can do to reverse inflationary expectations, without hurting growth, and the rest of the job must be done by fiscal policy. Since the markets had already discounted this action, sentiment is likely to be steady across the board. What is a bit open though is whether the entire range of RBI’s expectation — inflation will be contained, inflationary expectations steadied and the recovery sustained — will come about. Inflation is already peaking and this will also lower inflationary expectations. If global recovery does not become full-fledged, export-dependent, labour-intensive sectors like textiles will not get back to full throttle and restore all the jobs earlier lost. Also, RBI has itself indicated that consumer spending is yet to recover fully. If monetary tightening eventually leads to consumer credit becoming dearer, then consumer confidence and spending will not be fully restored and one element in the revival of aggregate demand will not pull its full weight.
Right now, with adequate liquidity around, there is no immediate expectation of banks raising interest rates. This, along with high business confidence and investment plans in the making, should take care of the key driver for high growth, investment expenditure. Banks, in fact, will find it difficult to raise wholesale interest rates as there is a large difference between domestic and international rates; external commercial borrowing is progressing at a fast clip and costlier domestic funds will only hasten the process of disintermediation. Where RBI can help matters is by urging banks to become more efficient and thus reduce their cost of intermediation. This is not all that Herculean as the Indian banking sector has, in recent years, invested heavily in technology and should now refashion its processes to reap the full benefits in terms of reducing transaction costs.
But there is only so much that the monetary authority can do to rein in inflation. Right now it is trying to contain the ill effects of a fisc gone awry. Hopefully, the renewed momentum in the disinvestment process and revenue buoyancy via higher growth will enable the fisc to get back to shape. The other area where RBI has no control in containing inflation, and which is the biggest contributory factor in the recent episode, is agricultural practices and food prices. Mismanagement on that front has been enormous and unless remedial action is taken, no amount of rate-tinkering will help. If growth with better distribution, the aim of the UPA government, leads to greater demand for food and continuous upward pressure on food prices, then macroeconomic policy will have to be managed better.
