With inflation remaining adamantly high, all eyes were trained on the Reserve Bank of India’s Third Quarter Review of Monetary Policy. With wide agreement that speculation was playing a role in driving inflation, reducing access to credit and raising the cost of credit were seen as the among the means to rein in the price rise. Fiscal developments have also raised the importance of monetary policy.

In the past, the principal response to inflation was a tightening of fiscal policy. This was because demand was largely driven by expansion in government expenditure. And when such expansion led to demand supply imbalances, the favoured solution (even when hurtful from a growth point of view) was a cut back in public expenditure.

Much has changed since then. Fiscal conservatism has meant that government spending on capital formation and the social sectors have been substantially reined in. Expenditures are now largely directed at interest payments, the wage bill and other “committed” current expenditures. As a result, sharp cuts in expenditure are difficult to realise and enforce. In this era of fiscal conservatism, high growth has been driven by credit, which has come to play an important role in fuelling demand in the private sector, especially through housing investments, automobile purchases and a raft of other debt-financed expenditures.

As a corollary, the central bank, which puts on a conservative face and claims that inflation targeting is its prime objective, has helped to keep credit-financed expenditures and, therefore, demand buoyant, by opting for an easy money policy and pumping liquidity into the system. Although unacknowledged, promoting growth driven by credit has taken precedence over keeping inflation in check in the central bank’s list of objectives. As a result, as former RBI Deputy Governor, S.S. Tarapore has noted (Business Line, 28 January 2011): “Superimposed on very low policy rates is the massive quantitative easing by way of large access to the repo window, large open market purchases and the reduction of the Statutory Liquidity Ratio.” Needless to say, when credit is easily accessed and interest rates are low, some of that money goes to finance the holding of stocks and contributes to the speculative thrust that even minor demand-supply imbalances generate.

In the circumstances, according to economists seeking market-mediated measures, monetary policy has become the key to addressing inflation, even if its efficacy is in doubt. In fact, from the point of view of the central bank this is the only option at hand and one in keeping with its own perception of what its role should be. Hence, in the context of the current inflation, the expectation was that the central bank would come down heavily on the side of those demanding the use of the monetary lever to rein in prices.

The RBI has indeed taken a small step in the expected direction by raising its reference, repo and reverse repo, rates by 25 basis points each. However, it has decided not to absorb excess liquidity from the system and reverse what has been an easy money regime. To many, an adjustment in rates equal to a quarter of one per cent is at best a weak manoeuvre, given the magnitude of the inflation problem at hand. In an almost defensive justification of this half-hearted move, the press statement issued by the RBI’s governor declares: “With the increases announced today, since mid-March 2010, the Reserve Bank has cumulatively increased the repo rate by 175 bps and the reverse repo rate by 225 bps. Additionally, the CRR was increased by 100 bps. Banks have responded to this calibrated tightening by raising their deposit and lending rates, suggesting strong monetary policy transmission.” The argument seems to be that since the RBI has done a lot in the past, a little at the margin is actually much. Unfortunately, what was done in the past has not worked, and there is no reason to believe that a small adjustment at the margin will make the difference.

The RBI’s reticence to tighten monetary policy is because it is under pressure not to reduce the flow of credit that is driving demand and keeping growth and profits high. Understandably, the corporate sector has been arguing against monetary tightening. Stock market speculators have turned bearish every time there are signs of a tightening of policy or when interest rates are even marginally tweaked. And banks, that have been riding the wave with a 24.4 per cent increase in non-food credit and a well-above 100 per cent credit deposit ratio over the last year, have been complaining about tight liquidity conditions. But what is surprising is the government’s support for a loose monetary policy.

Echoing that view, the Prime Minister’s, increasingly vocal, non-resident advisor, Raghuram Rajan, has issued a call from Davos for a cutback in fiscal spending and a persistence with quantitative easing as the way to growth with low inflation (Indian Express, January 27, 2011). Mr. Rajan is ostensibly against the use of monetary policy and, especially, a hike in interest rates. Reportedly asserting that “monetary policy can do only so much to control inflation”, he warned that “You don’t want interest rates to be raised to such a level that growth is killed.” The fact of the matter, however, as Tarapore has underlined, is that with the repo rate at 6.5 per cent and inflation at close to 8.5 per cent, the real reference rate in the system is significantly negative.

But Mr. Rajan (and presumably the government he represents) cannot be faulted for not bothering about inflation, which he seems to argue has to be dealt with from the fiscal side. A case is being made for curbing expenditure, by cutting subsidies, trimming big programmes and holding back on new ones, in order to deal with inflation. This “advice” too is a bit troubling. According to the report, Mr. Rajan believes that “if you can pass through crude oil prices, restrain food subsidy and do away with fertilizer subsidy, 90 per cent of what needs to be done on the expenditure side would be done.” This “macro” view clearly ignores how the actual economy works. Raising the administered price of food distributed through the public distribution system, hiking the cost of a universal intermediate like petroleum, and increasing costs of agricultural production, experience has repeatedly shown, is a sure way of aggravating inflationary trends. Whatever one’s view of the efficacy of monetary policy, recommending these as better ways of dealing with inflation defies logic. Moreover, by worsening the already damaged viability of crop production, it would worsen supply conditions and render the system more inflation-prone in the medium term.

The argument does not just stop at implicitly backing speculators and the corporate sector at the expense of the average consumer hit by inflation. There is a real possibility that among the “big programmes” that would be recommended for trimming would be the NREGS and among the programmes that would be put on hold would be the promised expansion of the extent and scope of food security programmes. If true, that is recommending the imposition of a double burden on a population already hurt by high inflation. That is a step beyond its refusal to adopt direct measures to curb speculation and structural reforms to redress supply-demand imbalances.