The Finance Minister’s emotional appeal may lead the RBI to do what it really shouldn’t.

The debate on growth and inflation continues in the context of the Reserve Bank of India’s (RBI) upcoming mid-quarterly review of its monetary policy on March 19.

While one may not argue for a zero price rise for practical reasons, even the norm of 5 per cent in the short run and 3 per cent for the medium term (compounded), mentioned in official documents, is on the high side, especially when it happens year after year on an ever increasing base.

It is in this context that the latest Union Budget’s assumption of an inflation rate of 6.5 per cent or thereabouts is disturbing. Does it indicate a New Normal for policy purposes?

Also notable is of the Budget’s projection of a nominal gross domestic product (GDP) growth of 13.4 per cent.

Nominal vs. real GDP

The targeting of nominal instead of the real GDP has become the flavour of the season, ever since the Danish economist Lars Christensen coined the term ‘market monetarism’ in August 2011.

‘Market monetarists’ reject targets such as inflation and unemployment and focus on monetary aggregates or the interest rate as policy instruments. They believe in rational expectations and the adaptation of markets to changes thereof. The favourable observations on the idea expressed by Mark Carney, head of the Bank of Canada and incoming Governor of Bank of England, has triggered interest in the matter.

This is not the place to discuss the concept and its operational implications for India. So far, we have had two separate benchmarks — real GDP growth rate and inflation. If both are clubbed together for whatever reason, given the Indian genius, we are likely to say that our target is achieved so long as the combined one is realised, even with inflation gaining at the expense of real GDP!

Of course, the Finance Minister has spelt out the break-up of the nominal anchor into the real growth and inflation rates — roughly 6.5 per cent each — to indicate the bases for his Budget figures that are in nominal terms.

The question is whether the RBI is going to adopt these for its full-fledged Annual Review for 2013-14.

Short-termism for Long Run?

Interestingly, in a brilliant speech entitled Is there a New Normal for Inflation? delivered in New Delhi on March 8, the RBI Governor demolished the case for the new theory. He clearly pointed out that price stability is essential to help investors and consumers make informed choices and contribute to growth. The Governor further buttressed his stand in a lecture on March 13 at the London School of Economics.

The only uncomfortable note, in an otherwise excellent speech, was the statement that estimates by the RBI using different methodologies put the threshold level of inflation in the range of 4 to 6 per cent before it starts hurting growth.

This range is quite high. Econometric results lead to conditional forecasts.

I would rather see the RBI commit ‘type-II’ errors from tightening of monetary policy, referred to in the Governor’s New Delhi speech.

One of the worst enemies of credibility, whether of the central bank or the Government, is the problem of time inconsistency — saying one thing for the long term and doing exactly the opposite in the short run for a temporary advantage.

There is the larger issue here of the coordination between monetary and fiscal policies.

Can Budget expectations be realised if the central bank’s estimation of the desirable growth of money supply has a different basis that is not consistent with inflation at 6.5 per cent?

There is enough time for the RBI to agonise over this question till the Annual Policy for 2013-14 is announced a few weeks later. The March 19 review will be a lame-duck affair anyway, since the financial year is coming to a close soon.

Contrary signals

Meanwhile, the current growth slowdown in industrial production and exports, along with double-digit consumer price inflation and absence of any relief in the latest wholesale price index-based inflation number, give contrary signals to policy making. This, even as the recent slowing down of non-food credit growth is welcome in the light of trends in deposits.

The protagonists of liberalisation claim that there will be a turnaround if interest rates are reduced because of RBI action. While agriculture and exports are well protected with relatively low borrowing rates, it is the manufacturing and the service sectors, especially the construction industry, that have the potential to benefit from fall in interest rates.

But the RBI’s last cut in rates has not had the desired effect, by and large. Will a decline in the equated monthly instalment (EMI) of repayment stimulate the demand for housing when the cost of even a small apartment is beyond the reach of the middle class? The reported decline in home loans despite the decrease in EMI is a pointer to the problem.

On the other hand, the prevailing high inflation rate has left little money for the common man to use for purchases of consumer durables after meeting the cost of the necessities of life.

Going by the various indicators bearing on inflation and liquidity, there is no case for any easing of the policy now. The so-called liquidity constraint is artificial due to the build-up of government deposits with the RBI that will pass off in a few weeks.

But, considering the emotional appeal of the Finance Minister to play ball, which must have struck a chord or two in the RBI management, I won’t be surprised if there is a reduction in policy rates or CRR or both.

(The author is a Mumbai-based economic consultant.)

(This article was published on March 14, 2013)
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