C.R.L. Narasimhan

Traditional dilemma of the central banker

24/01/2012 MUMBAI: Entrance of Reserve Bank of India (RBI) building in Mumbai on Third Quarter Review of Monetary Policy 2011-12 - January 24, 2012 in Mumbai. Photo; Paul Noronha   | Photo Credit: PAUL NORONHA

The Reserve Bank of India (RBI) will unveil its second quarter review of credit policy on October 30. Being one of the seven reviews of the annual statement, the forthcoming one would be expected to be an exercise in continuity. In a span of just 45 days or so, between two policy statements, the underlying conditions do not normally change very drastically.

Earlier, the RBI released the mid-quarter policy review on September 17. The first quarter review was on July 31. The annual policy for the year (2012-13) was announced on April 17.

Despite their frequency, the policy reviews never fail to excite market watchers. It is true that like so often in the recent past the forthcoming review will take place against a backdrop of sluggish economic growth and persistently high inflation. The monetary policy’s traditional dilemma of whether to cut rates to reverse the faltering growth trend or maintain the status quo in the face of continuing price pressures remains the same.

Except that there are, this time, more than the usual customary hints to the RBI from the new Finance Minister to drop interest rates. The pressure on the central bank is by no means subtle. In holding the tight monetary policy as being the prime obstacle to growth revival, the government is siding with the several chambers of commerce and industry organisations which have been consistently espousing the cause of a softer interest rate policy. Never mind that the RBI has equally consistently resisted such pressures, arguing that inflation is a far greater worry than the economic slowdown.

Nobody can fault the RBI for following an opaque policy. Its interest rate stance was revealed right at the beginning of the year when in the annual policy statement it brought down the repo rate by a larger than expected margin of 50 basis points (0.50 percentage points) but simultaneously stated that markets should not expect further cuts in the near future.

Yet, pressure from the government was always there, though not perhaps so explicitly as it is now. The government can now claim that it has done its bit to support the RBI in its battle against inflation. It has been the central bank’s frequent and well justified refrain that the loose fiscal policy has been aggravating inflationary pressures. The hike in diesel prices, the opening of retail trade to foreign investors, raising the cap on foreign direct investment (FDI) in insurance and pension sectors to 49 per cent are meant to project the government’s reformist zeal, having an important consequence of indirectly combating inflation.

Of course, the contrary view is that some of these measures will take a long time to fructify. Second, the diesel price hike has already had an adverse impact on inflation, while in the long-run it might help in better managing inflation expectations.

What are the hard facts on which the RBI will base its decision — to lower interest rates and /or the CRR (cash reserve ratio) or maintain the status quo?

The recent positive news on industrial growth needs to be sustained in subsequent months before anyone can proclaim a revival. Inflation remains a big worry, with wholesale inflation rising to 7.8 per cent in September. All segments of the WPI index have come under pressure.

Inflation expectations have increased. The limited increase in diesel prices might be just the beginning of further increases in controlled as well as non-controlled items. Whatever benchmarks the RBI has been relying upon — core inflation, food inflation or retail inflation — there is hardly any scope for optimism.

The global environment remains an enigma. The IMF’s latest report points to an universal slowdown. Though by no means still out of the woods, the eurozone countries stand to benefit from certain major initiatives of the authorities to support the countries in deep crisis. For the rest of the world, the actions of the European Central Bank and the U.S. Federal Reserve will have consequences with far reaching implications for their monetary policies. Global liquidity is set to receive a major boost and with it the prospect of aggravated imported inflation for India.

So, in sum, neither the conventional inflation benchmarks nor the near-term outlook — both global and domestic — suggests a rate cut by the RBI on Tuesday. It is, however, possible that the CRR will once again be lowered by 25 basis points (0.25 percentage points), following a similar reduction 45 days ago. Although liquidity is not an issue now, the CRR cut would be seen a sop to those who want a softer interest rate policy.

The connection between a CRR reduction and lower interest rates is not automatic. But several bankers, notably the SBI Chairman (who wants the CRR to be done away with), say that they were able to lower interest rates after the last CRR empirical evidence to establish the connection.


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