RBI shifts gears, finally

The Monetary Policy announced by the RBI recently has been prepared in difficult times — domestically and globally. Domestically, all important parameters are causing concern — the growth rate is far below the trend; large twin deficits, especially current account deficit, poor flow of credit to industry and stubborn inflation.

Globally, the recovery in the US is subdued, and the economic situation in the euro area, the UK and Japan is still a matter of concern.

In such an uncertain environment, the RBI has done a commendable job of signalling a change in approach and reducing, though very cautiously, the repo rate and the cash reserve ratio.

A slight reduction in the two rates amounts to a balanced approach, simultaneously addressing the issue of interest rates and tight liquidity conditions. It probably is a tactical way to indicate that the economic situation is sensitive and that the RBI is closely monitoring the economy. In the political economy literature, the central banker has to be conservative in approach with the basic aim of targeting the inflation rate.

It is also necessary to signal to the watchful international community that the central bank and the Government are in alignment on major economic issues. This step of the RBI will put to rest any such speculation.

Inflation targeting

It is a general perception in the market that the RBI had kept the repo rate above 7 per cent since May 2011 to address the issue of high inflation.

In India, the overall inflation rate continues to be high mainly because of food inflation, which has much to do with supply conditions, domestically and globally. Agriculture output has been dented because of the weak monsoon in India and drought-like conditions in many other countries.

In fact, the issue of tolerance level of inflation in India needs a review to meaningfully anchor inflationary expectations.

In advanced countries as well, there is a discussion on raising the levels of inflation targeting, as it gives more space for policy manoeuvring.

In India, in the last 23 years, annual inflation rate has been below 4 per cent only in four years; between 4 per cent and below 7 per cent in 8 years; between 7 per cent and 10 per cent for 7 years; and above 10 per cent in 4 years. There needs to be an extensive behavioural study on new tolerance levels of inflation, if any, in India, segregating the effect of food and non-food inflation, and the trade-off between growth and inflation.

Higher unemployment

An aam aadmi , a subject of concern for the political parties, would perhaps be mainly concerned about food inflation. And, it is the common man today who may be tolerant of inflation, but not of unemployment.

Using a monetary policy tool in such circumstances could be a sort of double-whammy for the aam aadmi, as high interest rates would imply lower investment and growth, resulting in higher unemployment, over and above high food prices.

In general, repo rate at 7.75 per cent is still high and having established a cautious approach by releasing the pedal gradually, and also acknowledging that an output gap has emerged, it may be useful now to reduce the benchmark rate more aggressively to meet the stated objective of encouraging investment activity and accelerating growth.

There is a precedence in December 2008 when the repo rate was reduced by 100 basis points from 6.50 per cent to 5.50 per cent and by April 2009 repo rate was down to 4.75 per cent. The economy faithfully responded by growing from 6.7 per cent in 2008-09 to 8.4 per cent in 2009-10.

However, it must be conceded that inflation in food articles at that time had continued to be high, even as inflation in non-food articles had come down substantially.

Rise in NPAs

The policy statement mentions that the NPAs are beginning to rise and the trend is mainly noted in public sector and old private sector banks, which is leading to risk aversion by banks.

It would be interesting to know the sectors where larger NPAs are being recorded. It probably could be the housing sector, as a large number of houses remain unsold, which is also reflected in the house price and transactions volume index published by the RBI.

In the case of Delhi, Bangalore, Ahmedabad, Kolkata and Chennai, while the housing prices have been rising annually, transactions have been declining significantly. This could be a cause of concern for banks’ lending to the housing sector.

The RBI’s macroeconomic review provides a focused discussion on the domestic and global economic situation.

It would also be interesting to have some information on the regional scenario within India. In the US, the Beige book is published eight times a year and two weeks before the meetings of the Federal Open Market Committee.

The RBI, with its network of regional offices, could provide information on a near-real time basis on the regional economy, which would be useful in assessing the actual economic condition.

(The author is RBI Chair Professor, Indian Institute of Management, Bangalore.)

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