Monetary policy: more than usual dilemma

C. R. L. Narasimhan
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In the run up to the credit policy review, due to be unveiled on July 30,the Reserve Bank of India (RBI) faces an acute problem of choosing the right policies, the type of which it never had to confront before.

The RBI’s concerns over the rupee’s fall will naturally find a place in the policy statement as the third leg of its policy “trilemma”. The two traditional objectives, supporting growth and maintaining price stability, remain.

Rupee depreciation

The large focus on the rupee depreciation does not obscure the fact that the RBI’s balancing act to reconcile growth with inflation is now made more complex with the rupee depreciation.

At stake has been the rupee depreciation as much as the extent of the rupee’s fall, the apparent inability of policy measures to arrest its decline that has exacerbated the problem. To counter that impression, the RBI unleashed a package of measures from the middle of the month to tighten liquidity in the system with the avowed aim of checking speculation in the rupee.

But the measures — announced on July 15 and July 27 — have been unconventional, and even if they have had the intended effect of curbing liquidity in the short-run, they will remain controversial for a variety of reasons.

There have been criticisms, including from the State Bank of India Chairman. He has pointed out that the two-stage measures are a roundabout way of making funds costlier.

The same outcome could have been achieved through a straightforward hike in the repo rate by one percentage point. The process would have been more transparent.

That point of criticism, widely shared by many analysts, however, misses the point that the RBI is entitled to surprise the markets with unconventional measures.

Besides, in the present context, a repo rate hike might be a blunter weapon, signalling a more complete reversal from the gradual monetary easing that the RBI has been pursuing recently.

Moreover, repo rate changes (as also in the CRR) are announced as part of monetary policy statement, a habit which the RBI might have been reluctant to change.

More substantial points of criticism centre on the impact of the measures on the bond markets. As intended, short-term bond yields have started moving up, and might start pulling up other short-term interest rates.

Over time, this would percolate to the banking system making bank lending costlier.

This will be highly detrimental to economic growth, which clocked just 5 per cent last year (2012-13).

Government borrowing

Equally damaging would be the higher cost of government borrowing. Already banks and institutions are demanding a higher yield on the bonds than what the government has been willing to offer in the first instance forcing the government to hike the yields in specific or reduce the quantum of bonds on offer. The higher cost of borrowing will naturally affect fiscal consolidation. Another reason why the government has to backtrack sooner rather than later.

But rupee concerns loom large. For now, the RBI appears to have succeeded in bottling up the rupee in a narrow trading range of 59-60 band. But the pressure on the rupee to slip back has been in evidence necessitating constant vigilance.

The expectation is that the forthcoming policy statement will very likely indicate a timeframe within which it might consider easing the rigour of some of these measures.

Conflicting messages

Rupee concerns apart, the policy has to reckon with the other two principal objectives of growth and price stability. As has been the case before all recent policy statements, recent macro data give conflicting messages. Industrial output continues to be in doldrums.

Index of Industrial Production

The Index of Industrial Production (IIP) declined by 1.6 per cent in May relative to last year. On the other hand, consumer inflation based on the CPI (consumer price index) index has been unrelenting, clocking almost 9.9 per cent in June.

Headilne inflation

Headilne inflation, too, which has been declining in recent months, has changed course although it is still below 5 per cent.

All these explain why the RBI’s tasks on Tuesday have become that much more complex.

But for observers, this might be the correct time to start looking at the whole of the monetary policy statement, not just to the section on monetary measures for understanding the extremely complex environment in which policy choices have to be made.



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