Managing inflation is all very well, but the RBI should address the grim reality of sagging growth. It should learn from the experience of 1988-99, when it favoured growth, assuming that inflation was a supply-side problem.

The recent easing of monetary policy started with a bang of a cut in CRR by 125 basis points and a policy rate cut of 50 basis points early this year. But the easing turned into a whimper after April.

The Reserve Bank of India (RBI) Governor Duvvuri Subbarao, after denying a further rate cut in July, continues to maintain a hawkish tone.

Last Monday, he emphasised his concern that inflation remains too high, but also added that domestic factors were responsible for the slowdown in the country's growth momentum, and that declining investments were a cause for concern. Is he trying to strike a new balance between growth and inflation?

The projection of inflation for this fiscal is at 7 per cent, and that of growth is 6.5 per cent.

While an inflation rate of 7 per cent is by no means a comfortable level, it is far better than the near double-digit levels seen till late 2011.

But the stark reality is that growth is sagging. A renewal of emphasis on revival of growth is vital for a variety of reasons: The economy is not overheated; inflation is not money-induced, is showing signs of easing and the pressure is more from the supply side than the demand side; there is a need for credit growth; and finally confidence needs a boost from any possible quarter.

Economy not Overheated

The economy now is not overheated, as during the pre-crisis period when Y. V. Reddy hiked rates, the CRR and imposed prudential norms to contain an asset bubble despite benign inflationary conditions. Global imbalances and mispricing of risks were assessed as serious problems. Even if we consider that potential growth has touched a new level, say, 7.5 per cent, the economy is still performing much below its potential.

After recovering from a dip in 2008-09, post-financial turmoil, the economy fell into a double dip in 2011-12 (see graph) and is sagging consistently for a variety of both domestic and global factors.

Investment and export demand are at their lowest. Any economic revival now will require support of credit from the banking system, partly due to less vibrant bond markets and partly due to drying up of foreign flows, including commercial borrowings.

However, the banking system is both liquidity- and capital-constrained. On the face of a slowdown in deposit growth, credit growth is primarily on account of the RBI injection of liquidity through its varied operations.

Such flows cannot result in an enduring commitment from banks for an expanded flow of credit to industry. At the same time, the recent cut in SLR by 100 basis points cannot serve the purpose of releasing bank funds.

On the contrary, it will only push up borrowing costs of the government.

The current inflation is not money-induced. Monetary conditions continue to be tight. The RBI has been in liquidity injection mode in the recent period, after being in absorption mode for over a decade, or since 2001. Broad money growth at below 14 per cent is one of the lowest ever seen.

Non-food inflation

Inflation in the current period is explained more by supply-side factors. The core non-food manufacturing inflation is not very high and has been softening and ruling at around 5 per cent since March.

Among the other components of non-food inflation, energy prices at the global level and those of industrial inputs do not seem to have the potential of hardening in the coming months, due to slackening demand across countries.

As a result, non-food inflation overall has moved down from double digits in most part of last year, to around 6 per cent currently.

Confidence Crisis

Confidence in macroeconomic management is hard to gain, but easy to lose. It has a spillover effect on the external sector, which can turn adverse very quickly in the face of a confidence deficit.

Post-global financial turmoil, India weathered the storm rather quickly and recovered more or less unscathed. It seemed to have entered a higher growth trajectory, with investor confidence and appetite growing. Unfortunately, after 2011-12, the economy reversed its positive trend and seemed to be falling deeper into a confidence crisis.

The change of leadership in the crucial policymaking Finance Ministry may help a bit, but as the Prime Minister’s Red Fort address tells us, there is no political consensus on many issues. Governance, overall, remains shaky.

On top of this, trends in external sector indicators have been worsening. This is cause for particular concern. India has in the past been through periods of unstable growth and painful adjustments, as a fall-out of weakness in its external sector.

A shift in monetary policy stance can, however, provide that ray of hope to revive confidence in the economy.

Learning from 1998-99

Dwelling on the monetary policy stance for the second half of 1998-99, the then Governor Bimal Jalan said that the RBI was faced with a monetary policy dilemma, as reflected in the need to reduce monetary expansion while, at the same time, nurturing real growth.

While a case could be made out for monetary tightening, in view of high growth in money supply, he felt that nothing should be done to dampen emerging signs of incipient recovery in the real sector.

He left the policy tilted towards growth on the consideration that inflation was mostly emanating from supply side, and not due to credit growth. His position was vindicated in later months. He reiterated this position in April 2001, when the country faced a similar situation.

This can provide a lesson in the present context when inflation is not money-induced, with its origins lying more in supply side factors.

Let RBI Rethink

This is the time for the RBI to do a rethink. Its stubbornness at keeping inflation, and inflation expectations at bay, is well-placed.

However, keeping an eye on inflation should not mean turning a blind eye to growth, which has never been the case with the RBI. Inflation management does not mean that the central bank becomes oblivious to other concerns. This is particularly so because monetary actions work with some lag.

Without waiting for the next policy announcement in September, the RBI should cut the policy rate as also the CRR by at least 25 basis points each.

(The author is Director, EPW Research Foundation. The views are personal.)

(This article was published on August 16, 2012)
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