The Reserve Bank of India (RBI) will unveil its credit policy review later today. As has been the case before every policy review, speculation is rife as to what the central bank will do for interest rates. This time, of course, the additional factor to be reckoned with is the recently announced reform measures.

Strange as it might seem, the announcement of a steep hike in the retail price of diesel on Thursday is seen as the starting point of the latest round of “big bang” economic reforms. The diesel price rise will inflict pain on the economy. It will push up inflation which is already well above all reasonable expectations. Transportation costs will go up and households will have to spend more on food and other items which are transported by trucks. So to give this basically unpopular measure a reformist tag would appear to be incorrect, unless (1) as many predicted correctly it would be a harbinger of other measures which are more closely identified with economic reform. (2) In the context of the need for fiscal consolidation the diesel price hike is obviously a plus point. But it has to be followed with other measures to rein in subsidies in both food and fuel.

By Saturday, it became clear that in finally taking the tough decision to increase diesel prices by a stiff Rs.5 a litre, the government was sending several messages that go well beyond the contentious issues of petroleum prices. A hike in the retail price of diesel was widely expected although it was by no means certain as to whether a government hobbled by political differences from both within the ruling UPA alliance and outside will act in the way it has. The hike which excludes VAT has already evoked strong reactions from many political parties. Assuming that there is no rollback, the diesel price hike could be the starting point of a series of tough, unpalatable economic measures that the UPA government was seen to be avoiding.

However, even while that came true, the government can hardly rest on its laurels.

The petroleum sector, even after the hike, cries for some more measures. Petrol prices have been decontrolled earlier and to get a handle on the well entrenched cross-subsidies they need to be made more transparent. The rather original method of restricting subsidised cooking gas cylinders to just six in a year to individual households is fraught with administrative risks. There is a fear that might lead to black marketing of cylinders. On the other hand, however, there is a glimmer of hope that private parties, including some well-known multi-nationals who had collaborated to set up large bottling facilities might finally get some relief. There is bound to be a large demand well above the “rationed limits”.

The government policy of subsidising the sector had destroyed any hopes of private sector participation.

As the RBI prepares to review its credit policy, the string of announcements by the government acquires a certain special meaning.

Two other reform measures — the opening up of retail sector and domestic airlines to foreign investors, if successful, ought to facilitate foreign exchange inflows. Those would be positive news for the external sector, which is now acutely dependent on short-term flows.

The diesel price hike lends itself to opposite interpretations for monetary policy.

Will the RBI cut rates on Monday or maintain the status quo?

Answers to that would depend upon whether the RBI thinks that the diesel price hike is the starting point of an earnest attempt on the part of the government to mend its finances. In the recent past, the RBI has consistently complained of government inaction in the face of a burgeoning fiscal deficit. So it had to fight the inflation battle single-handedly. With a new finance minister and first concrete proof of government’s willingness to take tough measures, the RBI has some leeway to go easy on interest rates.

The opposite view, of course, is that the diesel price increase is definitely inflationary. High fuel prices will harden inflation expectations over the medium term, Besides, inflation for August at 7.6 per cent is up from July (below 7 per cent). Price pressures will persist consequent on the diesel price increase. Considering that some of these reform measures might be rolled back, the chances of RBI cutting interest rates is practically nil, according to this view.

Turning to macro economic numbers, the GDP (gross domestic product) growth has slumped to below 6 per cent over the last two quarters. Industrial output is extremely sluggish as the monthly Index of Industrial Production (IIP) figures continue to demonstrate. The external environment has brightened, however, with the major break-through in the eurozone. The U.S. Federal Reserve has once again committed itself to an ultra cheap interest rate policy to nurture the modest growth.

However, the flood of money that the Fed releases would drive up global commodity prices and that will not be good news for the RBI in its continuing struggle to rein in inflation.

The message is that the recently announced reform measures, like many policy indicators, lend themselves to opposite interpretations as far as the monetary policy is concerned.

narasimhan.crl@thehindu.co.in

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