There is evidence that private consumption demand has not picked up and the recovery should be supported by stimulus packages

It is not uncommon that before any monetary policy statement from the Reserve Bank of India there is speculation on the central bank’s stance on interest rates. This time is no exception. Although its quarterly statements are definitely not about interest rates alone, much of the attention on the RBI’s pronouncements continues to be focussed on its interest rate stance.

The reason probably lies in the interest rate being the only policy variable which bankers and lay people alike connect with. Besides, there is a palpable sense of excitement in anticipating changes in the interest rate policy. That cannot be said of, say, the RBI’s take on the economy or the new measures contemplated by way of financial sector reform.

But all these and other things that the policy statements dwell on are as relevant to an understanding of the macro economy as the context in which the monetary policies are framed. In fact the justification for a specific interest rate action is found in the rest of the policy.

Two-way pointers

On the eve of the third quarter review of monetary policy, it is worth noting that there are as many pointers to an interest rate hike as there are to maintaining status quo. The economy has fared reasonably well with the GDP growing at a better than expected 6.1 per cent in the first quarter. Inflation based on the WPI index is no longer in negative territory but continues to remain low, only recently moving past the one per cent mark. Yet more recently available data will have to be examined further and in a larger context for the guidance they provide to the monetary authorities.

Latest growth forecasts for the current year (2009-10) have generally been more upbeat than earlier ones. Last week the Prime Minister’s Economic Advisory Council (EAC) in its Economic Outlook had projected a growth rate of 6.5 per cent for the current year. That is higher than the RBI’s 6 per cent forecast in its first quarter review of monetary policy in July. Last year (2008-09) the economy grew by 6.7 per cent.

There was a deceleration in the second half. The growth rate was down to 5.8 per cent from a robust 7.7 per cent during the first six months (March-September2008). The EAC expects industry and services to grow by over 8 per cent but agriculture hit by poor monsoons is forecast to be down by 2 per cent.

The inflation factor

For the interest rates policy, the implications of the recent growth statistics are several. The EAC’s higher GDP forecast is based on the assumption that the revival in industrial output — demonstrated by the double digit growth in August Index of Industrial Production (IIP) numbers — will further consolidate in the coming months. Clearly a continuance of the easy monetary stance will help.

However, growth and indeed macro economic stability depend on inflation. The deceptively low WPI inflation masks the fact that food inflation is running high. In its Economic Outlook the EAC has called the management of inflation risk, especially food inflation, the biggest challenge for the policymakers over the short-term. It expects the WPI inflation to be around 6 per cent by March-end. A hike in interest rates to counter inflation might be the orthodox remedy but is not indicated straightway for at least two reasons. Inflation is currently attributed to supply side factors. In addition to high food prices, elevated commodity prices, especially of petroleum, in international markets are fuelling inflation expectations.

According to the EAC, food inflation will have to be tackled through a multi-pronged strategy. It recommends that the rabi crop should be protected right through the season. Public distribution should be strengthened. Rice imports would provide a cushion. In general, supply-side factors are less amenable to interest rate changes.

Besides, there is evidence that private consumption demand has not picked up and the nascent recovery should continue to be supported by the stimulus packages. The highly accommodative monetary policy may have to reverse at some point but not at the present juncture, also because of political reasons.

The RBI clearly faces a dilemma of whether to signal higher interest rates or not. It seems very likely that on Tuesday it may maintain the status quo on the repo rates. There is however a possibility that the cash reserve ratio will be raised to impound excess liquidity. This approach again has its shortcomings: it is too blunt and, given the excess liquidity, it may not be a strong enough signal. It is also certain that whatever decisions the central bank announces on Tuesday will only be of a short-term nature, likely to be recalibrated depending on the changing economic environment.