The only question worth debating a couple of days before Reserve Bank of India (RBI) governor D. Subbarao announces his next move on Tuesday is: should he increase policy interest rates by 25 or 50 basis points?
The authorities have been fighting a losing battle against inflation and stern action is required if matters are not to spin out of control. Central bank data shows that households now expect inflation to be in the double digits even one year down the line. Such elevated inflation expectations could lead to a wage hike spiral in the next fiscal, despite the fact that trade unions no longer have the power they once used to. Inflation expectations need to be anchored quickly.
Despite the current focus on the price of onions, Indian inflation is no longer restricted to food. It has spread to industrial goods many months ago. That continues to be the biggest immediate threat to the Indian economy right now, with a widening current account deficit not far behind.
Yet, the economy is not overheated to the extent it was in 2008, going by various indicators such as bank credit growth, money supply growth and asset prices. Also, there are some signs that the monetary tightening in 2010, when the effective policy interest rates moved up by 300 basis points, is having an impact on consumer demand (though inflation could also be a factor here as budget-constrained consumers have postponed some purchases to make way in their household budgets for more expensive food).
RBI has also maintained tight liquidity conditions at the short end of the money market, with banks having to borrow overnight from it on most days. An increase in the cash reserve ratio does not make sense in this situation. The rupee has been kept relatively strong, another indication of maintaining a tight lid on domestic liquidity.
The Indian central bank has maintained the repo rate between 4.75% at the worst point of the financial crisis and 9% during the high inflation of mid-2008. This key policy rate is now at 6.25%, somewhere in the middle of this range. The repo rate needs to move closer towards its recent upper limit in case inflation continues to increase and inflation expectations get further unhinged.
All things considered, it would be prudent for RBI to increase interest rates by 25 basis points this week but send out a hawkish message on its future course of action. But a tighter monetary policy should be supported by a tighter fiscal policy in FY12 if the government wants to cool down demand and prices. What Pranab Mukherjee does on 28 February is thus very important.
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