Central bankers, as a species, are known to dwell between a rock and a hard place. Their remit in setting monetary policy is to balance the conflicting objectives of supporting growth and keeping inflation at bay. This is not an easy trade-off and the monetary policy announcement due on January 29 will not be the exception. High food price inflation and signs of accelerating growth have invited a rising clamour for monetary tightening from some quarters of the economist and policy community. But there seems to be an equally strong demand for restraint. One could argue that the current debate on monetary policy has been bogged down somewhat unnecessarily in the narrow question of whether monetary instruments can be effective in curbing food price inflation.
The Reserve Bank of India (RBI) has, through its statements and indeed its decision not to respond to food inflation data, indicated that it sees the food price spiral as a supply-side phenomenon. Monetary action that works by reining in demand is unlikely to help. The finance ministry appears to share this view. But there are others who believe that easy money abets inflation expectations and the inflation impulses set off by high food prices could embed themselves in the economy if monetary policy remains loose. The Indian central bank might want to tread the middle ground and remove some of the excess liquidity that is sloshing around (banks have been on average parking about Rs 90,000 crore of surplus cash with RBI every day) by increasing the cash reserve ratio, the fraction of bank deposits that RBI impounds. This is unlikely to work miracles though and unless supply conditions improve, food inflation is unlikely to abate.
However, the January policy decision needs to look beyond this issue and focus more on a bigger question. How quickly, for one, should RBI exit from the “super-accommodative” stance that it took in the wake of the global banking crisis of September 2008? As Lehman Brothers collapsed and blue-chip financial institutions across the Western world went into government receivership, the global financial institutions froze over raising the spectre of a prolonged depression in the world economy. RBI and other central banks tried to counter this quite literally by throwing money at the problem. Between September 2008 and January 2009, RBI pumped in roughly Rs 6,00,000 crore through a combination of cuts in reserve requirement and special liquidity facilities. It cut the repo and reverse rates, the signals which influence borrowing and lending rates, by four and a half percentage points respectively to encourage banks to lend at lower rates. It followed this up with an aggressive “quantitative easing programme”, buying bonds from banks in exchange for freshly minted money. In the first half of 2009-10, it bought back about Rs 57,000 crore of bonds, adding an equivalent amount of liquidity to the system.
RBI took the first steps towards altering its policy stance in the last quarter of 2009. In October, it hiked the statutory reserve ratio, the fraction of deposits that banks need to invest in government bonds, by a percentage point. It also jettisoned its quantitative easing programme from October. However, these were seen to be relatively mild gestures. Does it need to do more in the January policy? Current macroeconomic conditions make a case for more visible monetary tightening. Industrial growth has perked up somewhat unexpectedly, with the index of industrial production rates in the September–November averaging growth of 10.6 per cent. Other indicators such as the Purchase Manger’s Index (a monthly index of manufacturing activity) and automobile sales also point to considerable traction in the industrial. GDP for the second quarter of 2009-10 printed at a robust 7.9 per cent. The consensus expectation for GDP growth for this year is now in the ballpark of 7 per cent, a good percentage point above RBI’s own forecast of 6.
The combination of accelerating growth and a surfeit of cash in the financial system is known to breed inflation pressures. Food-price inflation may be supply-driven but there are signs that a demand driven core-inflation is slowly raising its head. Steel producers hiked prices recently and white goods manufacturers seem ready to hike prices in the near future. The wholesale price index (WPI), net of food, has started drifting up slowly from June 2009, indicating that some manufacturers at least are pushing up prices. After the recent spike in the WPI, it would be dangerous to ignore this insidious trend. The golden rule of monetary policy is to try and stay ahead of the curve. That is, to pre-empt inflation pressures rather respond to it.
Given the flow of data, RBI might find it imperative to tighten money supply a little more. However, the exit has to be slow and calibrated. A small increase in the signal reverse repo and repo rates or a hike in the cash-reserve ratio could just do the trick in the January policy. A more aggressive signal of tightening could hurt sentiment and dampen the economic recovery which is still in its initial stages. Credit growth is still weak at about 12 per cent.
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If the January policy appears too hawkish, the fear of rising interest rates could dampen both investment plans of companies and consumers’ decisions to borrow. The government, with its large fiscal deficit, is and will remain a large borrower. Clearly, the fiscal doves have queered the pitch for the monetary hawks and have reduced the policy space available to the central bank. While the central bank will have to reiterate its credentials as an inflation fighter, it has to be careful not to take away the punchbowl before the growth party has begun. Balancing this classic trade-off is easier said than done, but there is no escape from it.
RBI can let some steam off, however, by giving a piece of its mind to New Delhi’s spendthrift ministries and define what, it thinks, ought to be the budgetary parameters for a more prudent fiscal policy. Of course, one word of comfort for the central bank is that it is better to be stuck between a rock and a hard place than on the edge of a precipice!
