Tuesday, June 19, 2012

Observations on the mid-quarterly monetary policy review

In its mid-quarterly monetary policy review, the Reserve Bank of India (RBI) has decided to stay the course by keeping rates unchanged. In the backdrop of the recent dismal fourth quarterly GDP figures, the government, businesses, and several influential voices have been arguing that the high interest rates are adversely affecting growth. They, therefore, strongly advocate rate cuts to boost economic growth.

However, there are also several factors militating against any rate cuts. Primarily, real rates are lower than at any time in recent years. Core inflation has fallen below 5% and is on a downward trend. Further, the depreciating rupee, by making exports attractive and imports costlier, too has added to the inflationary pressures. Most importantly, the headline WPI based inflation rose to 7.55% in May from 7.23% in April, on the back of rise in prices of manufactured products, fuel and power and non-food primary goods. In addition, retail inflation too has been rising, lending credence to the view that inflationary expectations are not fully anchored.

Clearly, the RBI is worried by the recent upward trends in inflation and has preferred to focus on inflation, even at the risk of growth being compromised. It believes that inflation is a bigger worry than economic growth. It also believes that monetary policy, especially baby step cuts, may be ineffectual in restoring growth and the onus for that should be with the government which has to rein in its fiscal profligacy and also take steps to ease supply bottlenecks in infrastructure and agriculture

But there is a danger in persisting with tight monetary policy. Econ 101 teaches us that inflation can be either cost-push or demand-pull. In the former, negative supply shocks and other supply constraining factors contribute to increase in prices. In such conditions, interest rates can play very limited role in lowering inflation. In the latter case, inflationary pressures arise due to aggregate supply failing to keep pace with aggregate demand. Here, raising interest rates can help restrain demand growth and thereby lower inflation. 

The RBI's tight monetary policy stance since early 2009 has been dictated by the belief that inflationary pressures were being caused by demand-pull factors arising from an overheating economy where supply-side bottlenecks had become prominent. This necessitated raising interest rates so as to lower economic growth rates to sustainable levels. This strategy has worked nicely in terms of moderating growth and even bringing down inflation from its double digit levels of 2010.

However, now with growth having fallen well below the potential output (and thereby having attentuated the demand-pull forces), the potential for tight monetary policy to reduce inflation may be limited. In fact, high interest rates may be having the effect of restraining investments and thereby perpetuating the supply constraints. In other words, inflationary pressures may be getting built up by way of the higher interest rates discouraging investments.

If inflationary pressures are indeed being stoked through this channel, as they could be, then the RBI risks falling behind the curve. The downside risk of this is the possibility of an economy getting trapped in a stagflationary environment with high inflation and declining growth rates. Political paralysis will only compound the problems. A recovery from such situation may not be easy.

Hindsight may be the only way in which we can satisfactorily resolve the argument about which of the two, inflation or growth, is a greater problem facing the Indian economy at this point in time.

In any case, having decided to go along with the inflationary-forces-are-still-at-large hypothesis, the best that the RBI can now do is to wait for the first quarter 2012-13 GDP figures. If they do not show marked improvement, the RBI would need to moderate its inflation fighting stance and embrace monetary loosening before it becomes too late to stop a free-fall or self fulfilling downward spiral.

Another interesting feature is the fundamental difference between the respective policy approaches adopted by the RBI and the US Federal Reserve when faced with weak economic conditions. For sure, inflationary environments in India and the US stand at the two extremes. But whereas the Fed has thrown every instrument in the monetary policy arsenal so as to prevent the economy slipping into a deflationary trap, the RBI has been more circumspect about growth and has preferred to focus on inflation, even at the risk of worsening stagflation.

Whatever, the final outcome, the RBI should be complimented for sticking to its inflation-fighting strategy, even in the face of such overwhelming calls for rate cuts from the markets and the government. It is also a clear signal to the markets about its relative autonomy and a boost to its institutional credibility. In some sense, when we look back in history, the global economic tumult of the past five years may well be recorded as the time when the RBI earned its central banking spurs as a genuinely independent and professional central bank.  

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