The Reserve Bank of India (RBI) refrained from raising interest rates but increased the reserve requirements more than expected in its credit policy review. The surprise 75 basis points (bps) increase in the cash reserve ratio (CRR) is a catch-up with the rapid stride in inflation, which had exceeded the central bank’s projections a quarter earlier. Do the extra 25 bps compensate for the status quo on interest rates? The unchanged policy rates—inconsistent with the sharp 1.5 and 2 percentage points revisions in growth and inflation forecasts—are intended to lend primacy to growth. Notwithstanding the hawkish tone, the monetary stance is delicately balanced between growth and price stability.
Never an easy choice for central banks, weighing the inflation-growth risks was exceptionally difficult in the broader context of exiting the expansionary monetary-fiscal policies. Several factors motivated the choice of CRR over interest rates to anchor inflation expectations. To start with, it was pragmatic that liquidity adjustments precede price measures in the exit sequence: A rate hike would have no effect with three-quarter billion rupees worth of excess liquidity sloshing around. That borrowing costs would remain unchanged with the CRR tool also blended political preference with the central bank’s own caution. Better a laggard be than err upon the timing of withdrawal. Remember the monetary tightening that followed the downturn in 1997-98? The charges of investment overkill—unproven though—have dogged RBI ever since. This is the “low tolerance for error” in the return to normality.
How else can we reconcile the optimistic growth projections that suffuse the review and the heightened inflation risks ahead flagged alongside with the continuation of a crisis-level interest rate regime? RBI lifted its growth forecast to 7.5% in 2009-10 from the previous forecast of around 6.0% and expects this to be sustained in 2010-11. Simultaneously, it also upped its Wholesale Price Index inflation forecast to 8.5% from 6.5%. Surely this confluence would suggest a stronger signal through interest rates?
The central bank frankly admits its main policy instruments are at levels consistent with a crisis situation than with a fast-recovering economy. Curiously, in the post-policy press conference, the governor disagreed with a question that interest rates were out of synchronization with the real (growth) indicators. This is puzzling. The slack in resource utilization—admittedly, unevenly distributed—could not be so large. The raised growth forecast of 7.5% is not all that below the trend or potential growth rate of the economy (this is variously estimated to lie between 7% and 8% but is a contentious number). There’s also a likelihood of actual growth being marginally higher than projected growth, given the usually conservative forecasts of the central bank. The closure of the output gap is flagged as a key inflation risk in the near term, as is the expected “pressures on capacities” if growth gains momentum in 2010-11 as per expectations. If monetary policy is framed within a forward-looking setting, then was not now the appropriate time to move?
In “managing the recovery”, RBI’s key concern is the revival of investment spending, which has yet to take off convincingly. Other than investment, the evidence on the interest-sensitive components of private demand—for example, automobiles, real estate—is telling, with double-digit growth rates in some sectors and the resumption of increase in real estate prices. On the other hand, the risk of a hit to the income-sensitive segment—arguably a larger component of aggregate demand—from inflation is high, as we know from the sharp contraction in private consumption in early 2008. The central bank recognizes this threat in the growth-inflation trade-off beyond the short term. The probability of aligning interest rates down the road is now higher vis-à-vis reserve requirements, when the central bank catches up after reassuring itself of a self-sustaining growth dynamics.
The inflation-growth concurrence, which has complicated monetary policy at this point, has also to be disentangled from the larger issue of macroeconomic management of the withdrawal from expansionary policies. Zeroing in on the large and unsustainable fiscal deficit, RBI has correctly identified fiscal correction as a necessity in the monetary-fiscal coordination in this context. It has also candidly warned that the reversal of the accommodative monetary stance could be offset if unaccompanied by a fall in government borrowings. With RBI not abandoning the growth objective despite mounting price stability concerns, complementary fiscal efforts would be an exemplary coordination of macroeconomic policies. It is likely that the government will support this with some roll-back of discretionary stimulus measures, and possibly a consolidation plan, in the forthcoming Budget. This should restore credibility to some extent and contain adverse fiscal expectations to bring down long-term yields, especially critical to the revival of investment.
Finally, there are some noteworthy changes in the review statement. Moving towards leaner communication, this statement is considerably shorter—13 pages—than the previous ones that usually exceeded 30 pages and were more difficult to decipher. In another first, the review statement incorporates “expected outcomes” of the announced monetary measures. RBI deserves to be commended for clearer communication of the purpose underlying its monetary measures and their linkages with the outcomes. It should be especially useful in clarifying the impact of policies to all market participants.
Renu Kohli was, until recently, with the International Monetary Fund. Comments are welcome at firstname.lastname@example.org