Early signs of an economic recovery have brought back the classical dilemma faced by central banks: growth or price stability?
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India’s central bank faces this choice after a gap of nine months during which it cut its policy rate drastically from 9% to 3.25% and generated at least Rs5.6 trillion of liquidity through many measures to fight an unprecedented credit crunch and also lift a sagging economy.
Reserve Bank of India (RBI) governor D. Subbarao signalled the end of an expansionary policy regime by leaving key policy rates unchanged in the quarterly review of monetary policy on Tuesday. At the same time, he raised projections for both growth in India’s gross domestic product (GDP) as well as inflation.
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The central bank has not given any firm commitment about revising its growth target for the current fiscal year; it remains at 6% with an “upward bias”. But it has raised the projected year-end inflation rate from 4% to 5%.
This means while RBI is cautiously optimistic about growth in India’s Rs54 trillion economy, it is concerned about the likely rise in inflation. In monetary parlance, RBI has shifted its policy stance from “dovish” to “neutral”, but if one reads between the lines it is not difficult to see the underlying theme of the review—the measure-less quarterly policy is just a way to buy time before RBI tightens its monetary policy. That could happen as early as September or as late as April, depending on the pace of economic recovery and the trajectory of price rise.
The benchmark wholesale price-based inflation rate declined for successive six weeks between June and mid-July, but RBI is concerned about the fact that there has not been any sharp decline in inflation expectations—a key to the stance of any monetary policy.
Also See Nuts and Bolts of RBI Policy Review (PDF)
The decline in inflation does not signify any demand contraction, but is a statistical illusion reflecting the higher base effect of last year. Wholesale price-based inflation peaked at 12.91% in August and the so-called base effect will completely wear off by October, and inflation is then likely to start creeping up.
Even though inflation of manufactured products is negative, that of manufactured food products is high and primary food prices, too, continue to rise on uncertain progress of the monsoon. Moreover retail prices, as measured by the Consumer Price Index have remained high.
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These, combined with rising global commodity prices, will put pressure on inflation.
Another contributing factor to the rise in inflation could be the abundance of liquidity, as plenty of money stokes inflation.