The Reserve Bank of India’s (RBI) move to reduce its repo or lending rate to banks by 25 basis points, in its annual monetary policy for 2013-14 announced last week, seems to have been guided by the imperative to arrest falling growth.

The decision, however, is not in line with its own macroeconomic assessment, outlined in the Macroeconomic and Monetary Developments in 2012-13 report released on the eve of the policy. That report had clearly pointed out that in view of wholesale price index (WPI) inflation being above the RBI’s threshold and the same based on the consumer price index (CPI) ruling at double-digits, amid other macro financial risks, the space for policy action is very much limited.

Nonetheless, the central bank appears to have eased its guard against inflation in the latest policy. The ostensible logic is that it expects the WPI inflation to be range-bound at an average of around 5.5 per cent. Simultaneously, it has committed to reach the 5 per cent inflation level by March 2014, “using all instruments at its command”.

Though India was not one of the wrong doers, it suffered collateral damage from the global financial crisis of 2007-08 and the subsequent sovereign debt crisis. Besides, misdirected policies, both monetary and fiscal in the wake of the crisis, resulted in India’s potential growth, which was estimated at around 8 per cent in the pre-crisis period, being lowered to 7 per cent now. The RBI continued with policy tightening for two years, beginning with March 2010, on the premise that controlling inflation would involve some sacrifice of growth.

Too tight, too long

Since then, inflation has come down somewhat, but the March 2013 WPI numbers are still above the RBI’s comfort zone. At the same time, growth has been sacrificed by 2 per cent, along with the lower new ‘potential’ growth rate.

Since WPI and CPI based inflation numbers appear to be pointing to different directions, it would probably be a better idea to base our judgments on inflation, based on the GDP deflator. If we use the latest Advance Estimates of the Central Statistics Office, the inflation rate computed from the GDP deflator has declined only marginally from 8.2 per cent in 2011-12 to 7.9 per cent in 2012-13.

Either way, the notion of inflation moderating to the near acceptable level to justify even the latest monetary policy action turns out to be a myth.

There has been a strong apprehension that too tight a monetary policy for too long a period will only cripple growth, without actually having the required impact on bringing down inflation. The current growth and inflation numbers do vindicate that position. Monetary policy simply lacks the firepower to control inflation, when the latter has been identified to be supply-led.

What the central bank has been trying in the past three years is to dampen ‘inflationary expectations’. It hasn’t met with much success on that front. On the contrary, it has, for most of the occasions, tended to yield to the market’s expectations about policy rates. This time around, too, it has been no different. Market players were clamouring for a 25 basis points rate cut and the RBI delivered just that.

It is well known in economic theory that monetary policy is effective only when it involves an element of surprise. One wonders how the RBI will be able to influence expectations, when yet again it has played to the hands of market players.

The RBI has also projected a GDP growth rate of 5.7 per cent and an average WPI inflation of 5.5 per cent. This is the appropriate time to look at its projections for 2012-13, made in the last annual monetary policy announced on April 17, 2012. For the last fiscal, the RBI had projected a GDP growth of 7.3 per cent and WPI inflation of 6.5 per cent. While the former turned out to be much lower at 5 per cent, the latter was found to be much higher at 7.4 per cent.

Official divergence

It raises the question of how realistic are its current projections for 2013-14? The RBI can be said to have missed out on both its growth and inflation projections last year, partly due to the lag and cumulative effect of past rate hikes, and partly due to policy logjam. As far as projections for 2013-14 are concerned, its growth projection is at the lower end of a 5.7-6.7 per cent range predicted by a host of agencies (see Table).

The RBI expects a nominal GDP growth of around 11.2 per cent for 2013-14, compared with 13.7 per cent by the Government in the Union Budget estimates. The implicit assumption about inflation by the Government is between 6.7 and 7.3 per cent, which is much higher than the projection by the RBI: The monetary policy statement expects average inflation of 5.5 per cent and 5 per cent by March 2014.

Thus, we find the RBI’s expectation of both nominal growth and inflation to be lower than what the Government has in mind. It gives an impression of the two operating on two different trajectories.

The Government feels that its hard toil over the past few months in reviving investments should yield better growth rates, whereas the RBI seems sceptical on that score.

In fact, one would perhaps find the RBI as being too cautious on growth projections. If the monsoon turns out to be normal, and also temporally and spatially well spread, and the Government’s current efforts help to at least marginally invigorate the investment climate, it is possible for growth to end up somewhat higher at six per cent or so.

The inflation projections are anchored in terms of WPI inflation, which, in any case, the RBI seems reluctant to use as a guide for policy formulation. The lower WPI inflation is premised on soft ‘core’ inflation, though the RBI has pointed to the upside risks emanating from upward revisions in crop minimum support prices, the timing and magnitude of administered price revisions and, above all, food prices.

If these risks get contained, the RBI may be able to hit the WPI-based inflation projections. Thus, we may get slightly higher growth than what the central bank predicts and slightly less WPI inflation than the Government’s expectation.

As the risks to India’s external stability have lessened with the relatively lower global crude and commodity prices, the RBI has sought to give greater attention to growth concerns.

Reducing policy rates because of the focus on growth is justified; but to base it on the premise of moderation in price rise pressures seems unfounded.

(The author is Professor in Economics and Acting Dean, Xavier Institute of Management, Bhubaneswar. Views are personal.)

Related Topics