The third quarter monetary policy review released by the Reserve Bank of India (RBI) on January 29 had very few surprises. The reduction in the repo rate by 0.25 percentage points was widely expected. The cut in the cash reserve ratio (CRR) by an identical margin was perhaps less anticipated but does help the monetary transmission of the policy rate cut. The CRR reduction would result in an injection of Rs.18,000 crore of funds impounded with banks.

The reaction of the financial markets to the monetary measures has not been predictable. Since the small repo rate cut was already factored in, the stock markets would have reacted positively if only there had been a bigger rate cut or negatively if the RBI had not done anything. In the event, the absence of “bad news” was initially received well but later in the day as the RBI’s monetary stance became clearer there was a mild sell off of stocks, although that was later attributed to profit-booking at relatively high levels.

Fundamental to this review is an understanding of the policy stance. While conceding to a rate cut, the RBI is by no means announcing a retreat from the tough monetary stance which had taken the repo rates to historically high levels. The last rate cut was in April last, at the time of the annual policy statement. Since then, although the CRR has been reduced, the repo rates have held steady even in the face of mounting pressures and expectations. The RBI had more or less indicated that it would ease its monetary stance at the beginning of 2013. The question was by how much.

Another reason why the RBI effected a small reduction in the policy rates might be rooted in the following logic. The government has finally begun to heed the RBI’s persistent call for fiscal discipline to complement its anti-inflation measures. A number of “feel-good” policy measures have been announced to revive the economy, which it is hoped, will impact favourably on public finance. The Finance Minister has quite explicitly been committing to a fiscal deficit of around 5.3 per cent of gross domestic product (GDP), with promises of more drastic reductions in the near future. If the government has started to act can the RBI stay put with unchanged policy rates?

The question is important. Inflation remains a bugbear although the WPI (wholesale price index) inflation and the core inflation have been coming down.

In widely watched moves, the RBI cut its inflation target for March 2013 to 6.8 per cent from 7.5 per cent in July. Simultaneously, it lowered its GDP forecast for the current year to 5.5 per cent from 5.8 per cent earlier, bringing it in line with nearly all official as well as non-official forecasts. However, even the immediate direction of monetary policy is not set by these two actions entirely. Growth has been declining by various parameters. That calls for an easier interest rate policy. Inflation by some important measures has come down. Yet, the RBI does not think it will decline considerably more from its current levels and become a non-issue. Besides, the recently introduced consumer price index-based (CPI) inflation has shot up to double digits, (CPI index may not be the official reference point but it does influence inflation expectations).

Amid this contradictory evidence what should the monetary policy do from now on? The guidance at the end of the policy paper explains the monetary stance.

“With headline inflation likely to have peaked and non-food manufactured products inflation declining steadily over the last few months, there is an increasing likelihood of inflation remaining range-bound around current levels going into 2013-14. That provides space, albeit limited, for monetary policy to give greater emphasis to growth risks.”

Elsewhere, the RBI has made it amply clear that there are significant risks to macroeconomic management.

High up in the pecking order is the risk from the twin deficits, the current account deficit (CAD) and the fiscal deficit. As the review puts it, “financing the CAD with increasingly risky and volatile flows increases the economy’s vulnerability to sudden shifts in risk appetite and liquidity preference, potentially threatening macro-economic and exchange rate stability. Large fiscal deficits will accentuate the CAD risk, further crowd out private investment and stunt growth impulses.

Global risks remain elevated. Very recent news from the U.S. is disappointing. Its economy contracted unexpectedly in the fourth quarter. The euro area’s problems linger on and are increasingly taking on political dimensions with adverse consequences to the rest of the world too.

As far as inflation is concerned, demand pressures might have ebbed somewhat but supply side constraints remain (notably seen in food inflation) and need to be addressed expeditiously.

Bankers are increasingly becoming risk averse as the level of non-performing assets goes up and accountability issues crop up.

The key to stimulating growth is a vigorous and sustained revival in investment. That, in turn, depends upon a number of factors, including infrastructure development and better governance.

Finally, it ought to be clear that the repo rate cut does not automatically lower the interest rates on loans. That will depend upon the decisions of individual banks. It is hoped that the banks would also heed the concerns of depositors, especially the pensioners and others solely dependent on interest income from bank deposits. For banks, the spread income is important but it is hoped that they do not rush to cut deposit rates to please their borrowers.

narasimhan.crl@thehindu.co.in

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