Given the economic slowdown, the clamour for a cut in policy interest rates with or without a simultaneous reduction in the cash reserve ratio (CRR) was intense. Consequently, there has been a deep sense of disappointment among market participants at the Reserve Bank of India’s decision to maintain the status quo in its mid-quarter review of credit policy. However, the fear that the RBI has abruptly changed tack and is reversing its stance of softening interest rates seems misplaced. In its annual policy statement of April 17, the RBI announced a larger than expected 0.50 percentage points cut in policy rates but made it amply clear that future rate cuts should not be taken for granted. The moderation in core inflation, a consequence of the slowdown, gave the RBI some elbow room then. Yet inflation has always remained a concern and monetary policy’s traditional task of balancing the often conflicting goals of supporting growth and maintaining price stability is becoming more complex by the day. In just over a month after the annual policy statement, there has been a deterioration in both the global and domestic macroeconomic environment. The eurozone sovereign debt problem has continued to weigh on the global recovery. Of special consequence to India, it has heightened risk aversion leading to a slowing, even withdrawal, of short-term capital flows. That in turn raises serious concerns over managing the large current account deficit.
Moreover, steps towards fiscal consolidation along with various supply side initiatives so critical for inflation management have not made any headway. It is not for the first time that the central bank is holding the government accountable. The real clincher for the RBI has been the realisation that inflation remains a potent problem even at a time of perceptible economic slowdown. Economic activity in 2011-12 moderated sequentially to touch a low of 5.3 per cent in the fourth quarter, though for the whole year it was 6.5 per cent. Deceleration in industrial production from the supply side and weak investment from the demand side have both contributed to the slowdown. The index of industrial production (IIP) increased by just 0.1 per cent in April. All of this ought to have tilted the balance in favour of a rate cut, but the high numbers for overall inflation both at the wholesale and retail levels have clearly weighed with the RBI, which makes the novel point that interest rates are playing a relatively small role in the current slowdown. Consequently, a further reduction in the policy interest rate at this juncture could exacerbate inflationary pressures rather than supporting growth.