The Hindu Business Line : Monetary policy focus: Barking up the wrong tree?

These are hard times for the Reserve Bank of India — not because it is short of money but because there is, perhaps, an excess of it in the financial system. Policy formulation and response pose new challenges — `controllable' (may be) goods inflation, but `unmeasured' asset price inflation, whose precise impact on the general price level remains a mystery. And all this is beyond the ever-present central bank dilemma of achieving the right mix of growth and inflation, which, in broad terms, are seen in conflict with one another.

In recent weeks, the benchmark price index has overshot the RBI-expected range of 5 to 5.5 per cent. So can one jump to the conclusion that interest rates must go up? It would seem a no-brainer.

"Inflation is always a monetary phenomenon" is almost a tautology. What matters is whether the supply of goods can be augmented in the short-term to match excess money. The answer in today's global economy must be an unambiguous `yes'. A domestic supply shock no longer raises the spectre of inflation, given our large forex reserves and (therefore) the import option. A good monsoon will also cool price pressures.

The bottomline is that inflation could (and can be made to) behave independent of interest rates. Quite possibly, increasing interest rates will not dampen inflation. Equally, holding them will not necessarily increase inflation — such is our state of knowledge of how interest rates and liquidity affect the economy. In a sense, therefore, the interest rate decision — whatever it is — in this quarter's monetary policy review sidesteps the big picture.

India's enormous competitive advantage in wages is driving the exports of software, services and manufactures. Incomes and profits are high. Extraordinary paper wealth is being created through booming stock markets and property. These are exogenous to the central bank's actions.

Despite the economy being on a consumption and investment binge, there are no great alarm bells on, only small upticks in, inflation. Evidently, the supply of index goods is more or less keeping up with demand.

The risk factor

So what can go wrong? Bank credit is growing rapidly, funding investment in infrastructure, industry and commercial and residential property as well as current consumption. But what are the leverage and quality of assets financed and repayment capacity of loans to small businesses and individuals? It all seems to boil down to due diligence in credit appraisal on the part of banks amidst their scorching pace of business growth.

A potential hard landing for asset prices — negligible though the possibility is at the moment — and its fallout on banks is clearly the biggest risk. Tight lending standards and stringent bank examination and supervision are essentials.

Ultimately, the health of the banking system is more critical than monetary and interest rate posturing. The RBI and its Governor know this only too well.

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