Monetary policy at crossroads

All eyes are on the Reserve Bank of India (RBI) monetary policy announcement of January 24, 2012. Some top policy advisers in the government have explicitly stated that the RBI should reduce interest rates. Governor D. Subbarao, as part of forward guidance, has said that a decline in interest rates is on the cards, but has cautiously added that it is not possible to indicate precisely when monetary policy will be eased.

Those pleading for a reduction in interest rates point to the year-on-year fall in food prices to minus 3.36 per cent. There are shrill noises that this signals deflation, and hence the case for reduction in interest rates. The expected slowdown in real growth to 7 per cent (some analysts expect it to be lower) and the sluggish industrial growth makes out the case for industry to be given a stimulus by way of an interest rate reduction.

INFLATION THREAT PERSISTS

Pronab Sen, Chief Economist of the Planning Commission, in a percipient observation, says that the fall in food prices is essentially because of the base effect and in the next few months food inflation is likely to rise back to the 6-7 per cent range. When food inflation was at the higher reaches of the teens, no hearts bled asking for a sharp increase in the repo policy rate to double digits!

The overall inflation rate is persistently over 9 per cent and although it may fall in the ensuing period, largely because of the decline in food prices, there are as yet no signs of a significant and enduring reduction in the overall inflation rate. Moreover, fuel inflation is still over 15 per cent.

The fiscal situation is precarious and the gross fiscal deficit of the Centre, in 2011-12, could be 6 per cent of GDP or even higher. With the government's borrowing programme being raised sharply over the budgeted figure, crowding out is inevitable. To minimise the disruption in the commercial sector, as also to prevent yields on government securities rising, the RBI is undertaking substantial purchases of government securities under its Open Market Operations (OMO).

The upshot of all this is that inflation is likely to remain stubbornly high. Unlike in 2008, when the RBI rapidly brought down interest rates, the present macro indicators are not encouraging and a premature easing of monetary policy could rekindle inflationary pressures.

The external payments position is a cause of some concern as the current account deficit (CAD) is likely to be around 3 per cent of GDP and there have been substantial outflows of portfolio capital.

GO SLOW ON EASING

Advocates of monetary policy easing would argue that political economy imperatives warrant a reduction in policy interest rates. While baby step reductions would appease the strong commercial lobbies, such reductions would not meet political economy compulsions. In the past, monetary policy has remained unaffected by political economy constraints of impending elections. In 1977, just before the elections, the RBI undertook a sharp tightening of monetary policy with a 10 per cent incremental cash reserve ratio (CRR).

Again, during the foreign exchange crisis of 1991 and the absence of effective governance, the RBI went ahead with a massive monetary tightening of interest rates, reserve requirements and direct controls. As such, the RBI should not take account of the present political compulsions. Any easing of monetary policy should be on the merits of the case.

When inflation hits double digits, there is strong support for monetary tightening, but the moment inflation falls back into single digits, the lobbies for interest rate reductions gather momentum. As monetary policy is eased, inflation raises its ugly head. Needless to say, monetary tightening should always be faster than the subsequent easing. The old central banking dictum is that interest rates should go up by ones and down by halves.

Given that in recent years the RBI has opted for baby steps while tightening, it cannot easily relax monetary policy. As such, there is great merit in a long pause before reductions are made in policy interest rates.

There is a viewpoint that if policy interest rates cannot be brought down, the CRR could be reduced. The CRR is the most potent monetary policy instrument and if the situation is such that policy interest rates cannot be reduced, it would be a serious error of policy to reduce the CRR. After the easing of monetary policy in 2008, the tightening of policy interest rates has been of the order of 3.75 percentage points since March 2010, but the CRR was raised by only one percentage point. As such, a reduction in the CRR would not be an appropriate policy response.

It would be best to wait till March 2012 before taking a view on monetary easing. Too early an easing could result in a resurgence of inflation. As the sage monetary economist, the late Professor P. R. Brahmananda said: “Not caring about inflation is like going into battle without caring for the wounded, the dying and the dead”.