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RBI’s action: a suboptimal policy mix

RBI’s action: a suboptimal policy mix
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First Published: Wed, Jul 27 2011. 01 13 AM IST
Updated: Wed, Jul 27 2011. 01 13 AM IST
The central bank rolled back a few years and proceeded to shock financial markets with a 50 basis points hike in the repo rate. The previous regime at the Reserve Bank of India (RBI) viewed surprising markets as a useful tactic. Under the current governor, RBI preferred to be more transparent and believed in guiding markets about near-term policy direction. The July rate action was thus a clear departure from this template.
The surprise was all the more telling because of the information available since the June mid-term assessment when RBI last hiked the repo rate. Based on high-frequency indicators, industrial growth has disappointed while non-food Wholesale Price Index (WPI)-based manufacturing inflation (a proxy for core inflation) appears to have peaked. To be sure, other activity indicators show strength while there seem to be a few upside risks to inflation in the form of suppressed electricity prices and the resilience of global commodity prices to multiple uncertainties.
On balance though, a safe course for RBI would have been to hike the policy rate by 25 basis points and remain equivocal about the future course of action.
The central bank clearly thought otherwise.
While it is difficult to pinpoint the reason for this step, we conjecture that two significant developments since the June review hardened RBI’s approach.
One was the eurozone leaders’ summit last week which seems to have put in place a credible mechanism to deal with the eurozone periphery sovereign crisis. That appears to have lessened global uncertainty and the event risk that was hobbling global financial markets through June and the first half of July.
Second, the way government carried out fuel price adjustment at the end of June has worsened the outlook for government finances. Recall that the price hike was marginal and is slated to net only Rs 21,000 crore to oil companies while the duty cuts may end up costing both the central and state governments Rs 36,750 crore. Had these cuts been neutralized by indirect tax hikes, the exercise would have qualified as fiscally prudent. Rather, the duty cuts have crystallized the impact of petroleum subsidy on fiscal deficit. Between the absence of any clear-cut plan to cap and roll back subsidies and a reluctance to hike taxes, there is a good likelihood that the FY12 fiscal deficit/GDP ratio will overshoot budget estimates by 0.8% to 1%.
In an environment of above-trend growth and elevated global commodity prices, high fiscal deficits may end up entrenching high inflation expectations.
Note also that the high revenue and fiscal deficits are taking up the space for infrastructure investment by the government, thus further delaying supply responses. To sum up, absent government policies to augment potential growth and to dampen excess government consumption, RBI decided to do the heavy lifting.
From RBI’s perspective, it is a bold step that will burnish its inflation-fighting credentials. From a macro perspective, the mix of loose fiscal policy and tight monetary policy is suboptimal and may turn out to be toxic. Going forward, I expect RBI to refrain from hiking in the September mid-term assessment as near-term inflation readings may lie in line with RBI trajectory.
A. Prasanna ,Vice-president, ICICI Securities Primary Dealership Ltd
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First Published: Wed, Jul 27 2011. 01 13 AM IST