The Hindu Business Line : Quarterly Review of Monetary Policy: Dr Reddy’s shock treatment

The RBI seems to be sacrificing growth — albeit marginally — in pursuit of the impossible target of reducing producer price inflation. Is the central bank pressing the brake when the Government has its foot on the accelerator, asks S. VENKITARAMANAN

The RBI Governor, Dr Y. Venugopal Reddy, seems determined to leave a mark on central banking by taking a hawkish stand on fighting inflation even at the risk of a reduced — albeit slightly — outlook for growth. This is evident from his latest monetary policy statement, which announces that the repo rate be increased by 50 basis points from 8.5 per cent to 9 per cent and the cash reserve ratio by 25 basis points to 9 per cent with effect from the fortnight begi nning August 30, 2008.

The central bank has also revised the GDP growth projection for 2008-09 from the range of 8 per cent to 8.5 per cent, to around 8 per cent, barring domestic and external shocks. The priority is obviously, as before, to bring down the current “intolerable level of inflation” to a level of below 5 per cent as soon as possible and to around 3 per cent over the medium term.

At this juncture, the Governor admits the realistic policy endeavour would be to bring down inflation from the current level of 12 per cent to a range of 7 per cent by March 2009.

Hawkish stance

Obviously, the Governor has chosen to ignore advice from some quarters to stay his hand in regard to further tightening of interest rates, bearing in view the softening of crude price and agricultural prospects. He has followed the example of hawkish central banks such as the European Central Bank, which has taken a stance on controlling inflationary pressure by a tight monetary policy. The Governor is at pains to point out that the growth of money supply is increasing and that attempts should be made to bring it down, if necessary, by lowering the credit growth of the banking system. This is obviously an attempt at carrying the monetarist philosophy a bit too far. In particular, the Governor has taken pains to warn the banks that they should not overstep the target of credit expansion beyond what the RBI suggests.

This is a policy of central bank’s direction with a vengeance and almost makes a mockery of autonomy of banks to deal with the demand for credit, of course subject to prudential norms. This also calls into question the declared objective of the Government of India to provide credit to all sectors of the economy — in particular, the agricultural sector — at reasonable rates in an increasing measure. Whether the RBI is pressing the brake when the Government of India has its foot on the accelerator, is a matter to be seen as the year goes on. There seems to be scope for better coordination.

Another turning point

Obviously, we are at another turning point in the history of central banking in India. A similar situation was witnessed in the mid-1990s when the RBI tightened money supply and succeeded in reducing the rate of growth of the economy substantially.

Whether Dr Reddy is leaving behind such a legacy in the pursuit of his goal of tight inflation control is a matter, which the future historians will have to ponder over. It may well be that the inflation fighter did not sacrifice too much of growth but is he going to succeed in slaying the demon of product price inflation?

The markets have reacted in a stunned manner to the bank’s stance. The Sensex and Nifty have fallen sharply. But, that is by itself not as important as the general question whether we are fighting the wrong battle.

The Governor’s statement on macroeconomic development itself points out that as compared to the wholesale price inflation of 11 to 12 per cent, the consumer price inflation in India, measured by various indices, has ranged between 7 per cent and 8 per cent.

This is unlike the wholesale price index, which reflects producer price inflation. It is worth noting that most other central banks of the world focus on consumer price index, rather than wholesale price index. But, the RBI seems to concentrate on the WPI, which is essentially driven by global inflation in prices of crude oil and food. Whether tightening domestic liquidity and demand in India can influence producer price inflation or the WPI, which is made up of crude oil, food, steel and other globally traded commodities is a matter, which the economists of India will be in a position to answer.

We seem to be sacrificing growth — albeit marginally — in pursuit of an impossible target, namely, that of reducing producer price inflation by tightening domestic demand in a country which does not account for a relatively significant part of global demand to influence prices. This is a matter for experts to pursue.

Shock to the economy

Overall, the Governor has given a shock to the economy and it is hoped that the Government of India will reconcile its objectives of higher growth with the Governor’s pursuit of inflation management, especially of producer price inflation rather than consumer price inflation.

has to be an explanation as to how growth can be sustained, at least at the level of 7 per cent, which the RBI has now been arriving at.

One last point. There is a considerable throw-back to monetarist heyday in the Governor’s emphasis on M(3) growth being reduced through management of bankers’ advances. I am intrigued by a statement in the policy, which states “The total overhang of liquidity reflected in the balances under the LAF, the MSS and Central Government cash balances with RBI taken together declined from an average of Rs.2,42,370 crore in April 2008 to Rs 1,45,200 crore in July 25, 2008.

Does this not amount to monetary contraction? Or is it expansion in RBI’s interpretation? If my analysis is right, there is obviously withdrawal of reserves from the public instead of monetary expansion!