In raising policy rates on Tuesday, the Reserve Bank of India (RBI) can still claim to be the last bank standing as almost all other central banks have either paused or cut rates over the past month. And in doing so, RBI showed remarkable strength standing up to intense public pressure to pause. But for all purposes, it also signalled this would be the last rate hike at least till March 2012. These contradictory actions underscore the inherent struggle between public pressure to pause and the lack of any real evidence to support the action.
The uneasy balancing act was most apparent in Tuesday’s almost tortured policy statement. Since last January (following the inexplicable pause in December 2010), RBI had repeatedly stressed that curbing inflation dominated all its other objectives. To justify Tuesday’s rate hike, it fell back on the old argument of moving in “baby steps”, i.e. a sudden shift in stance would unhinge inflationary expectations.
The promise of a pause was justified by falling back on another old argument that inflation would come down in the next six months. That inflation will come down in January-March next year rests to a very large extent on the impact of base effects arising from a sharp rise in inflation in the first quarter of this year. But these base effects are fleeting at best; May onwards, even the most modest projections of sequential inflation points to headline inflation rising again.
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Isn’t monetary policy supposed to be forward looking with lagged effects on the economy that can stretch anywhere between six and 18 months? Does a signal to pause actually anchor inflationary expectations or make it come unhinged even more? Ah well!
To make the promised pause consistent with growth, RBI cut its growth forecast for this year to 7.6%. Activity has been slowing undeniably and a bit more realism from policymakers is always a good thing. In downshifting its growth forecast, RBI cited the slowdown in investment, driven by slower clearance and execution of projects, high inflation and rising interests as the major factors. What it did not mention is that corporate investment has been languishing since 2008.
What appeared to be a cyclical malaise then is now threatening to become a structural malady. Macroeconomic uncertainty both about the near term—when inflation will peak and growth trough—and about the medium term—whether India will go back to the 9% growth trajectory—is the reason why despite tight capacity, corporate India hasn’t been investing.
The government clearly has the dominant role to play in calming fears that India’s medium-term growth prospects are tarnishing. But ending the current inflation cycle quickly and decisively falls in the central bank’s purview. Pinning one’s hope on fleeting base effects doesn’t fill one with confidence that this inflation cycle is over.
All that said, RBI needs to be congratulated unequivocally for finally deregulating the interest rate on savings accounts. In doing so, it dismantled one of the last remaining vestiges of our paternalistic attitude to protect the “less-sophisticated” investors such as pensioners and the poor. There may have been many reasons for doing so, but presuming them to be naïve was both untrue and disrespectful.
Jahangir Aziz is senior Asia economist, JPMorgan Chase.
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