This mid-term review—October 2009—of monetary policy was perhaps one of the most difficult in recent times. Not only did the Reserve Bank of India (RBI) have to weigh the inflation growth trade-off, but it also had to take a call on exiting some of its crisis-level monetary support measures. Central to this jugglery were the persistent food price pressures, excess liquidity alongside rising stock prices, a disparate conjunction of the real-financial linkages and a yet-to-emerge, even revival of aggregate demand. In pairing these risks, both economic uncertainty and political economy have prevented RBI from taking the big step, i.e., reversing the interest rate regime, but it would have been uncharacteristic to have ignored price stability altogether. A tactful balancing, therefore, has played out in the arena of “extraordinary” monetary support; this is a subtle egress to signal inflationary concerns without disturbing the nascent growth momentum.
Paradoxically, it is doubtful if the outcome of the review could have been any different.
With a concerted, counter-cyclical fiscal monetary push having been used for the first time by Indian policymakers, it was doubtful that the central bank would walk away from growth at the very first signs of its revival. For the answer to the key question on the growth front—how dependent is the recovery upon monetary fiscal support, and whether it will self-perpetuate henceforth—is uncertain at this point. Demand activity indicators are mixed, even conflicting. Although manufacturing output averaged a smart 7.4% (year-on-year) in June-July against the 1.1% average for January-May, the easy monetary conditions have not yet translated into a surge in bank lending, indicating both weak economic activity and high costs. Labour market movements—the tightening of which would help confirm a self-sustaining recovery—are also unclear: They are improving in sectors such as auto, cement and, to an extent, in some service industries, but are nebulous across the board.
Illustration: Jayachandran / Mint
Add to this economic uncertainty the fact that the government’s fiscal expansion is still in motion, to which the central bank is committed. In balancing the risks, the central bank is preparing to change track, laying out the ground, but its commitment to demand support—through maintaining a low-interest rate environment—has taken precedence.
That said, a very hawkish tone signals that the monetary stance has now reversed; the weights have dominantly and firmly been placed upon price stability, and the growth objective has been relegated to the next order.
What helped RBI on the price stability front is the expected seasonal moderation in food prices with fresh arrivals of winter supplies, as well as the relatively low spillover risk of a generalized price increase in the absence of demand-side pressures—with a negative output gap, 0.4%, growth is well below trend. While RBI is worried about the trending up of headline inflation, the dominant presence of supply-side pressures afforded it some policy space at this juncture; at present, it could confine the use of monetary policy to prevent inflationary expectations from becoming embedded. As a clear picture of some liquidity indicators has emerged—the completion of three-fourths of the government borrowing by the first half of the year, a low credit offtake and the resumption of non-bank funding sources—RBI can manage liquidity levels to balance prices and genuine credit needs without fearing crowding out or not providing monetary accommodation to fiscal policy. Combined with distinctly hawkish communication, RBI can cheerfully address inflationary risks for now with these measures.
The central bank’s second worry was the incongruous divergence emerging between the crisis-time monetary measures and the post-crisis economic reality. There were the “extraordinary” monetary support facilities coexisting with excess liquidity bordering on Rs1.2 trillion daily, a stock market recovery that almost doubled in the last six months, foreign capital pouring into the country due to its improving growth outlook, real economic indicators looking more normal than below-trend, and upbeat optimism all around. Clearly, the situation was becoming embarrassing. So a gentle beginning has been made by legitimizing some hard facts: RBI is restoring the statutory liquidity ratio to its mandated 25% (lowered to 24% in November) when banks are voluntarily holding close to 30%, and it is bringing forward the end of some crisis-time funding facilities that were not of much use anyway. This is more signalling than real impact.
As RBI’s preferred combination is to set in motion an exit through the withdrawal of some now superfluous monetary support measures and a more active liquidity management, the next logical step would be to restrict open market operations. Indeed, there have already been some signals to this effect. For instance, RBI restricted its outright purchases in traditional government securities to Rs57,500 crore in the first half of 2009-10, against the scheduled Rs80,000 crore announced in March; and it has reserved its options for the second half, too, by not specifying any amount while announcing the government borrowing calendar. It also scaled back its open-market operations in September by keeping its stock of market stabilization bonds unchanged from August levels (Rs18,800 crore), offsetting the liquidity impact of rising Union government surplus funds held at RBI.
Looking ahead, though no road map for the exit is laid out, it’s clear that unconventional measures will be wound up sooner than later, followed by the more conventional tools such as reversal of the cash reserve ratio and interest rate hikes.
Renu Kohli was, until recently, with IMF. Comments are welcome at firstname.lastname@example.org