High interest rates seem like they are here to stay for a while. Or at least that is what one gathers from the Reserve Bank of India Governor Raghuram Rajan’s latest bi-monthly monetary policy review statement. The policy has predictably left the RBI’s benchmark overnight lending (‘repo’) rate and the cash reserve requirements for banks unchanged at current levels. But more important, it talks about sustaining the current disinflationary process over the “medium-term”, wherein consumer price index (CPI) inflation is to be contained within 6 per cent by January 2016. According to Rajan, the balance of risks around this medium-term inflation path “are still to the upside, warranting a heightened state of policy preparedness”. Simply put, the RBI’s focus is no longer on achieving 8 per cent CPI inflation by January 2015 — which seems within reach — but on the much lower 6 per cent target. So, any rate cuts would require inflation falling to the latter levels, even while the RBI “will act as necessary to ensure sustained disinflation”.
Such a tight monetary policy stance has far-reaching implications at a time when the Centre is committed to a medium-term path of fiscal consolidation. It leaves an economy that is battling a slowdown which is more than three years old and bereft of either fiscal or monetary stimulus support to enable a recovery. This is quite the opposite of the period that followed the 2008 global crisis, which saw both the Centre and the RBI resort to excessive fiscal and monetary loosening. Now, we know that was a huge mistake, since the resultant growth rebound was temporary while inflationary pressures were unleashed down the line. But the danger this time is erring on the opposite side, by tightening both fiscal and monetary policy simultaneously. This will not improve the prospects of an economic recovery in the near-term. Neither will it make as much impact as some people think on inflation, which has more to do with supply-side factors. These mainly relate to issues of farm productivity and poor agri-marketing infrastructure that aren’t amenable to control through conventional monetary policy tools.
The present situation could do with fiscal belt-tightening in conjunction with interest rate cuts to bolster overall investor sentiment and spur demand in sectors with high multiplier effect such as housing. The RBI’s focus should be on ‘core’ non-food manufacturing wholesale inflation rather than the CPI. Core inflation, which captures demand-side pressures in the economy, is something that it can control through raising interest rates. The fact that core inflation is ruling well below 4 per cent offers enough room for a more accommodative monetary policy. The RBI’s approach of targeting CPI inflation needs a reappraisal as it entails high interest rates even in an environment of low investment and consumption demand.