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It takes two to do policy tango

It takes two to do policy tango
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First Published: Tue, Jul 29 2008. 10 27 PM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Tue, Jul 29 2008. 10 27 PM IST
It is not surprising that Reserve Bank of India (RBI) governor Y.V. Reddy has increased interest rates in what could be his last monetary policy. Inflation is way too high and there are other signs that the economy is still mildly overheated. But the intensity of the attack on inflation does seem a bit of a shocker at first glance. Few had expected a 50 basis points hike in the policy rate and a 25 basis points increase in the ratio of cash that banks have to park with the central bank.
Illustration: Jayachandran / Mint
Has Reddy gone too far? We would argue that there is a good reason why the RBI governor has had to tighten the screws so fiercely. And that reason lies in New Delhi.
Economic policy at this juncture should be focusing on bringing down aggregate demand. This key parameter consists of local consumption, local investment, net exports and government spending. The central bank has some control over the first three components of aggregate demand, but none whatsoever on the fourth. That is where part of the problem resides.
The government has been merrily fanning demand and inflation through its growing fiscal deficit. Consumers are not being asked to pay market prices for fuel. Civil servants have been promised a pay hike. Farm loans have been waived. These are just some of the ways the government is boosting demand at the very time when the central bank is trying to keep it under control.
India’s real fiscal deficit is now at levels that have not been seen in the past five years. It is also one of the highest in the world. This government should ideally have used the torrents of money that flowed into its tax coffers, thanks to the economic boom, to mercilessly slash the deficit. Instead, the windfall has been frittered away in all sorts of populist schemes.
Given the fiscal mismanagement that we have seen, it is not hard to see that almost the entire onus of dousing the inflation fire has been dropped at the central bank’s door. The lack of spending discipline by the government effectively means that the private sector has to be hit with higher interest rates. In other words, interest rates will keep getting pushed up with every widening of the fiscal deficit.
The ideal solution would be for spending discipline by various parts of the government. But that’s too much to expect in the run-up to a national election. Fiscal policy will continue to be loose. And monetary policy will have to be tight.
Can RBI fight the battle alone? Write to us at views@livemint.com
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First Published: Tue, Jul 29 2008. 10 27 PM IST