Monetary threat

In its mid-quarter monetary policy review only three months ago, the Reserve Bank of India (RBI) refrained from cutting any of its policy rates. At the same time, it struck a distinctly ‘dovish’ note, pointing out that “monetary policy has to increasingly shift focus and respond to threats to growth from this point onwards”. It reinforced this message of monetary accommodation on January 29, by lowering both its lending (‘repo’) rate to banks as well as the proportion of their deposits to be compulsorily held as cash reserves without earning any interest. But the latest mid-quarter review on Tuesday, in contrast, suggests a rethinking of stance. While the RBI may have acted like a dove by reducing the repo rate by a further 25 basis points to 7.5 per cent, its tone this time is distinctly ‘hawkish’, as revealed in the statement that “the headroom for further monetary easing remains quite limited”.

So, what has changed in the last three months? Well, obviously inflation, that has remained stubbornly elevated, contrary to the RBI’s earlier expectations of its “steady moderation” going into 2013-14. But the real villain on that score has been food prices, which have driven up official retail inflation from 9.7 to 10.9 per cent between September and February. This, even as the annual price increase in non-food based manufactured goods – also called ‘core’ inflation – has fallen from 5.7 to 3.8 per cent over this period. According to the RBI, without food inflation coming down, anchoring “inflationary expectations” among the public becomes difficult. That may be true, but how can keeping interest rates high in any case help contain price rise in wheat, potatoes or onion? Monetary policy at the end of day is effective only in controlling ‘core’ inflation, which has clearly ebbed in recent months.

The question one needs to actually ask today is whether a lowering of rates will further exacerbate inflationary pressures. The answer: Quite unlikely, given the significant overcapacity plaguing most industries, from cement and automobiles to power generation equipment. The current state of demand limits the extent of pricing power available with manufacturers, thereby rendering hawkish monetary policy redundant from an inflation perspective. On the contrary, such a stance has a greater risk of worsening the current slowdown in growth and investments, adversely affecting public welfare through loss of incomes in addition to higher prices for essential articles of consumption. Under the circumstances, it may well be worth taking the lesser risk, if at all, from sharp reductions in both the repo rate and the cash reserve ratio requirement for banks. These will help bring down their overall cost of funds, especially when banks have limited flexibility in reducing deposit rates in view of sticky consumer inflation. The RBI can always shift gears in the event of any signs of overheating. Those seem very remote as of now.