All eyes will be on the RBI Governor, Dr D. Subbarao's monetary policy announcement of October 25. Formulation of the Reserve Bank of India's monetary policy, even in normal times, is an unenviable task, but the ensuing policy comes against the backdrop of an unusually difficult scenario, both global and national.

In India, fiscal policy provides no support to monetary policy. On the contrary, the increase in borrowings by Rs 53,000 crore in the second half of 2011-12 will add to the problem of monetary management.

While the RBI needs to signal a continuing tight monetary policy, to enable the borrowing programme to go through, it will have to be liberal in its open market operations and/or provide for a larger accommodation at the repo window. This will inevitably result in upward pressure on the government's cost of borrowing as also in the crowding out of commercial sector credit. And the upshot will be that the overall policy will not be conducive to an anti-inflationary stance.

The external scenario is of little comfort to the authorities. Sluggish conditions in the global market will inevitably affect exports while imports would rise, thanks to the distinctly over-valued exchange rate. The balance of payments current account deficit (CAD) will push towards the 3 per cent of GDP level which would cause concern to the authorities.

Real GDP growth in 2011-12 could end up close to 7.5 per cent, and while this is a good performance in the context of the global slowdown, the lobbying for a halt to monetary tightening is gathering strength.

Don't change stance

Industry is screaming blue murder, and now economists have joined the chorus crying for a halt to the further tightening of interest rates. It could be argued that credit expansion in the first half of 2011-12, at Rs 1,51,072 crore (3.8 per cent), is clearly lower than the expansion of Rs 1,80,040 crore (5.6 per cent) in the corresponding period of the previous year.

The inflation scenario, which is the primary concern of the RBI, is raging at 9.8 per cent, on a year-on-year basis, which is clearly not acceptable and well above the tolerable level of 5 per cent. It would appear that monetary policy is the only wing of economic policy fighting inflation — the other wings of overall economic policy are merely following an open-mouth policy of talking down inflation without taking any effective measures.

In the recent period there have been some pertinent studies by RBI economists. According to the Working Paper by Mr Deepak Mohanty and others on Inflation Threshold in India: An Empirical Investigation , an increase in the Wholesale Price Index (WPI) inflation beyond 5.5 per cent has a negative impact on growth. A premature change in the policy stance could harden inflationary expectations, thereby diluting the impact of past policy actions. The Paper argues that the inflation objective, or target level for inflation, should be lower than the inflation threshold as there are lags in the monetary policy transmission process.

Another Working Paper titled Why Persistently High Inflation Impedes Growth concludes that the central bank's objective of containing the inflation perception to 4-4.5 per cent is consistent with the need for balancing growth maximisation, threshold inflation of about 6 per cent and maximising low inflation.

These two studies are outstanding seminal contributions on monetary analysis and economists in banks and elsewhere who readily pronounce on monetary policy would do well to imbibe the contents of these Papers.

Strong action

It is sometimes argued that as the RBI did not undertake aggressive policy action earlier, it should now not undertake strong policy action. It has, time and again, been explained that it is important to take strong policy action well before the upper turning point of the cycle. In fact, if this is followed, the upper turning point can be delayed and the economy can creep along the ceiling of growth for a longer period.

Now that monetary policy was not used aggressively during the upturn of the cycle, should RBI put a pause to the series of interest rate increases? Such a move would be disastrous as inflation can get totally out of hand. The longer the RBI delays strong policy action the more inflation gets entrenched in the system.

The RBI need be no apologist for its monetary tightening. It would be best if, on October 25, the RBI raises the repo rate from 8.25 per cent to 8.75 per cent and also raises the cash reserve ratio from 6.0 per cent to 6.50 per cent. While these measures may appear harsh, if what we want is a quick and sharp abatement of inflation, there is no alternative to strong monetary policy action. The window of opportunity for strong monetary policy action is very narrow and the RBI should take early action before the window shuts.

While there is some advantage in advanced guidance on the course of monetary policy, excessive guidance can severely curtail the effectiveness of monetary policy.

(The author is an economist. >blfeedback@thehindu.co.in )

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