‘Supply-side inflation tends to spill over through its impact on expectations’

The Reserve Bank of India has been under pressure from across canvass to cut the key policy rates. The rate cut demand has become vociferous of late. Will the apex bank give in to this demand when it meets on October 30 for the second quarter review of the monetary policy? An eminent economist, Subir Gokarn as Deputy Governor handles monetary policy at the central bank.

In this interview with The Hindu, he gives an insight into the RBI thinking on very many issues. Excerpts:

The government has taken a series of measures to fix the fiscal deficit and attract foreign investments. How is the central bank viewing these?

Let me first remind you that the reduction of the Repo rate in April signalled a reversal in the policy stance. Since then, actions have been determined by continuing assessment of risks to growth and inflation. The recent measures taken by the government will address some of the key risks that the RBI has been highlighting in recent policy statements. The impact of these and any other measures taken before our second quarter review on October 30 on growth and inflation trajectories will certainly be taken into account when the policy decision is made.

How far can monetary policy be used as a tool to cool price pressures?

Many people view monetary policy as being ineffective in the face of supply side inflation Therefore, they see RBI’s interest rate stance as inappropriate in the current inflationary situation. However, when we look back over the evolution of both theory and practice of monetary policy, this view was first tested and found faulty by the policy response to the first oil shock in the early 1970s. When central banks took an expansionary stance to accommodate the growth slowdown that the shock induced, inflation quickly accelerated despite slow growth. The understanding that came from this experience, and which provides a strong foundation for monetary practice today, is that, while a tight policy stance may not directly address supply-side pressures, it certainly helps contain the possible spill-over from these to a more generalised and entrenched set of inflationary pressures. In short, supply-side inflation tends to spill over through its impact on expectations. If there is no policy response, these can quickly spiral out of control. An appropriate monetary stance can check this process. Yes, there are adverse impacts on growth to be considered, but the alternative in the form of runaway inflation could be much worse in the longer term.

There are signs of political uncertainty after the recent diesel price hike and the opening up of sectors such as multi-brand retail. Do these developments make the RBI cautious?

I think that everyone is on the same page as far as the need for fiscal consolidation goes. The government set up a committee headed by Vijay Kelkar to recommend ways in which this could be achieved. However, the political situation makes it clear that finding a broadly acceptable way to do this is a significant challenge. From the RBI’s perspective, a reduction in the subsidy bill is seen as a very important component of the overall solution, because the subsidy bill has been a very large contributor to the widening of the fiscal deficit. Further, since oil is such a large import, higher domestic consumption on account of artificially lower prices is also contributing to a large current account deficit. The twin-deficit challenge cannot be addressed without fuel subsidies being brought down. As far as the impact of these steps on RBI’s actions is concerned, I reiterate what I said in an earlier response: all these factors will be fully taken into account in assessing the growth and inflation trajectories and the risks surrounding them in the second quarter review.

Some economists, particularly at foreign brokerages or banks, see merit in the RBI’s decision to hold rates in the last three policy meetings. However, critics say these organisations don’t talk the same language when it comes to their home economies. What is your view?

I can’t comment on the perceived disparity between analysts’ recommendations on Indian policy and their employers’ positions on their home economies. We are dealing with an extremely complex global and domestic economic environment and, in this situation, all analysis can potentially contribute to a better understanding of the situation and, consequently, better decisions. For every policy decision, assessments are made in a very elaborate and rigorous internal process, which also takes due account of the public debate. Views expressed in this debate are considered on their merits and not on the basis of where they came from.

Why have hefty reductions in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) as well as April’s 50 basis point cut in rates did not result in an equal drop in lending rates by banks?

A sweeping statement like this may not be warranted. But, in general, the issue of transmission is an important one, and the RBI studies its dynamics carefully. Actual lending rates are determined by overall business conditions, which influence demand for credit and cost factors such as money market rates and liquidity conditions. The so-called weighted average lending rate (WALR), which captures actual transaction rates, is, perhaps, the best measure of what is happening across the system, rather than the rates that are publicly announced. Analysis suggests that this rate has been sensitive to changes in policy rates and liquidity in the tightening cycle, and is likely to be so in the loosening cycle as well.

Bad loans are mounting for public sector banks, especially those with exposure to troubled sectors. State Bank of India, for instance, was hammered by investors because of the rise in non-performing asset (NPA) provisions although its quarterly profits had jumped. High interest rates and a worsening economic slowdown could make more loans sticky. How does RBI perceive this and what measures need to be taken?

The RBI has been watching the asset quality situation very carefully. While the increase in NPAs is obviously a cause for concern, from a systemic viewpoint, the current level does not pose a threat, given the relatively high level of capital that the system has. However, the rise needs to be contained, with appropriate measures that take into account the sectoral and macro-economic dimensions of the problem.


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