RBI to govt: It’s your turn now

Now that the Reserve Bank of India (RBI) has surprised the markets yet again, this time by not reducing rates, what should we expect its policy to be in the future? Its guidance is couched in central bank-speak about “the evolving growth-inflation dynamic” and “a continuing assessment of external and domestic developments that contribute to lowering inflation risks”. But the crux of the argument is that the government has done nothing.

RBI says the reason it “front-loaded” a reduction of 50 basis points in April was because it expected that the government would take steps to reduce the fiscal deficit and take other “supply-side initiatives”. It adds that “factors other than interest rates are contributing more significantly to the growth slowdown”, another swipe at the government. By not raising fuel prices, the government has prevented “much needed adjustment in aggregate demand”. It says the government’s inability to rein in subsidies is “crowding out public investment”.

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Mint’s Nirajan Rajadhyaksha and Manas Chakravarty look at the implications of RBI’s decision to leave interest rates unchanged and what it will mean for the economy.

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In short, the central bank has fairly and squarely blamed the government for the slowdown in growth. That’s not all—it says “the persistence of overall inflation both at the wholesale and retail levels, in the face of significant growth slowdown, points to serious supply bottlenecks and sticky inflation expectations”. In other words, the government is not only responsible for the slowdown in growth, but also, by not taking steps to augment supply, it is to be blamed for the high inflation. Moreover, since the widening current account deficit is “symptomatic of demand-supply imbalances” and a “pointer to the urgent need to resolve the supply bottlenecks”, the government is responsible for the current account deficit as well. It’s a scathing indictment of the government and, regardless of whether one agrees with his policy, governor D. Subbarao needs to be commended for his blunt speaking.

RBI’s stance seems to be that unless the government does something to reduce the fiscal deficit and ease supply constraints, it cannot reduce interest rates. Does it follow that, in the future, unless the government takes action on these fronts, the central bank will not cut rates? In sum, RBI is saying it has done all it can and can no longer carry the can for the government. It’s now up to the government to act. As the Royal Bank of Scotland economist Gaurav Kapur puts it, “RBI is saying there are limits to what monetary policy can do to revive growth.”

What does this mean for the economy and for the markets? Here’s the clincher: RBI says, “While growth in 2011-12 has moderated significantly, headline inflation remains above levels consistent with sustainable growth.” RBI seems to be suggesting that unless the government acts, even the current low level of gross domestic product growth is not sustainable. Does India’s new normal rate of growth stand at 5%?

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