The balance of the Reserve Bank of India's policy stance would shift if growth fell consistently and substantially below the trend growth rate, estimated at 8 per cent, according to the RBI Governor, Dr D. Subbarao.
The RBI's current monetary policy stance is anti-inflationary with the short-term signal rates being upped 12 times since March-end 2010.
“At low inflation and stable inflation expectations, there is a trade-off between growth and inflation. But above a certain threshold level of inflation, this relationship reverses, the trade-off disappears, and high inflation actually starts taking a toll on growth,” the Governor said in his speech at the Stern School of Business, New York University.
Estimates by the RBI using different methodologies put the threshold level of inflation in the range of 4 to 6 per cent. “With the wholesale price index-based inflation ruling above 9 per cent, we are way past the threshold. At this high level, inflation is unambiguously inimical to growth; it saps investor confidence and erodes medium-term growth prospects,” said Dr Subbarao.
The RBI's monetary tightening is accordingly geared towards safeguarding medium-term growth even if it means some sacrifice in near-term growth, he added.
Pointing out that monetary tightening works by restraining demand, Dr Subbarao said that in as much as the fiscal stance is supportive of demand, the monetary stance has had to be more aggressive than otherwise. For monetary policy to be more supportive of growth, it will be necessary for fiscal consolidation to take root more firmly.
As India emerged from the crisis, the Government adopted a revised road-map for fiscal consolidation. Nevertheless, meeting the road-map targets is going to be a formidable challenge, the Governor said.
“The quantum of non-discretionary expenditure — salaries, pensions, interest payments — is large and this cannot be adjusted easily, at any rate in the short term. By far the largest component of discretionary expenditure is on subsidies — on food, fertiliser and petroleum products,” said Dr Subbarao.
He explained that even as the Government pursues a quantitative target, it also has to be mindful of the quality of fiscal adjustment — that is to prune unproductive expenditure and increase productive expenditure which is necessary for raising the potential output of the economy.