The Hindu Business Line : Credit policy

The first quarter review of the monetary policy by the RBI makes the priorities of central bank very clear. It has inflation control as the top of its agenda, and rightly so. Inflation is affecting millions of people across the length and breadth of the nation and has to be tackled on priority. Growth definitely will be hurt over the short term but it is the price one has to pay.

What else could the central bank have done? Central banks around the world use interest rates as the single biggest tool to affect changes in the money supply and hope to control inflation through this. However, inflation is not only a monetary phenomenon. In the context of recent inflation experiences in India, fiscal solutions are questionable. Waivers of farm loans, reduction of income taxes, and implementation of Sixth Pay Commission report would do more harm than good so far as inflation control is concerned.

States are doing no better by giving free power to farmers and heavily subsidising the use of fertilisers. The bill for all such fiscal programmes and incentives offsets the measures by the RBI to contain money supply. In fact, the monetary and fiscal policies are moving in mutually contradicting directions. The former is sucking liquidity and the latter is indirectly injecting it by subsidies and waivers.

Therefore, the RBI is using the limited tools at its disposal to its best advantage from the monetary angle to contain inflation. The cash parked at the RBI by banks (CRR) would be liberalised once inflation comes under control. This is unlike loan waivers and pay increases, which are a permanent invoice to the treasury. The CRR parked would become capital over the medium term.

High CRR and repo rates would also augment savings (because of higher interest rates on deposits), which will turn into investment over the medium term and increase growth, provided the capital-output ratio remains constant.

Monetary policy can only affect growth (as well as inflation) over short terms. Once inflation is under control, monetary loosening will have to start. Sound fiscal policies should back a freer monetary regime, if growth should sustain without interruptions.

Given the limited scope of monetary policy, the RBI may continue to tighten money supply till it feels that the tightening has had some appreciable outcome.

M. S. Sunil e-mail

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