The Hindu Business Line : A costly status quo

Never before in recent times has the Reserve Bank of India faced the kind of dilemma it confronted in fashioning monetary policy to economic events in its third-quarter review for 2007-08. On the one hand, credit growth decelerated to 22 per cent compared with 32 per cent twelve months ago. Total resource flows from the banks to the commercial sector slowed 10 per cent over a year. The money, debt and foreign exchange markets remained “stable”. Headline inflati on turned southward to around 4 per cent, and even domestic food inflation seemed under control. Capital inflows surged and more seem likely with the US Fed cutting rates. The GDP forecast was scaled down to 8.5 per cent. All these seemed to warrant softer interest rates. On the other hand, money supply, at 21 per cent, was still higher than the targeted 17 per cent, and global oil, grain and commodity prices began climbing, rekindling fears of inflation. All these factors added up to make a case for harder interest rates, perhaps for a hike in CRR or repo rates, whatever monetary policy thinks is good to pre-empt price pressures. In its third quarter review, the RBI ducked its way out — it did nothing.

For those who think global inflation could infect prices here, the RBI’s inaction may appear risky; those who feel that the decline in credit growth and lower GDP forecast needed the stimulant of an interest rate cut will feel grateful the central bank did not increase interest rates. The RBI’s decision to maintain the status quo on interest rates does not mean status quo for the economy. With the US interest rates due for another dip, capital inflows will mount, as interest rate differentials increase. That suggests pressures on liquidity and more costly sterilisation; the Budget should illustrate just how much this mop-up of excess liquidity is costing the nation. As to global inflation, so far there is no policy hint how the economy can be insulated; even with targeted subsidies, input costs will rise as the productive economy is run on more costly fuel. Price stability, in the event, may be elusive indeed.

It would have been far more productive to reduce interest rates, even with the threat of global inflation. Higher growth has always been the best medicine for feverish prices, and the domestic economy still has a lot of slack, with the rural sector waiting for investments. The RBI’s previous policies had successfully reduced credit growth, so reductions in interest rate would have increased it and, with it, the chances of sustained growth in a world simmering with gloomy sentiment.

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