Expansionary monetary policy has reached the end of the road. Firms and bond markets may need to prepare for higher interest rates a year later.
That is the sense one gets while reading between the lines of the monetary policy review announced by Reserve Bank of India (RBI) governor D. Subbarao on Tuesday.
His decision to leave interest rates and the amount of cash that banks have to compulsorily park with RBI unchanged is both expected and welcome. Much has been written and said about why the central bank should not tinker with any of its major policy levers right now. This newspaper saw no reason to disagree with the overwhelming consensus.
Illustration: Jayachandran / Mint
But this could be more than a temporary pause before RBI starts cutting interest rates once again. The central bank began an aggressive rate cutting spree in October, when the global economy was headed for total collapse. For example, the repo rate, at which RBI pumps liquidity into the banking system, was slashed from 9% in early October to 4.75% in July in a bid to spur bank lending. The government pursued an aggressive counter-cyclical fiscal policy to support domestic demand; its spending held up the economy even as private consumer spending and corporate investments tumbled.
The result: the economy seems to be recovering, but inflation has reared its ugly head.
Subbarao has said that RBI will try to keep inflation in the range of 4-4.5%. That range will almost surely be breached by the end of this fiscal year. The forecasters who RBI surveys regularly said in June that median wholesale price inflation in the first quarter of 2010-11 would be 5.9%.
Subbarao has been blunt in his call for two road maps on how to reverse policy once the time is ripe, one from the central bank he heads and another from the government. For example, he has made it clear that the central bank will have to suck out excess liquidity once the economy recovers: RBI will have “to be ready with a road map to reverse the expansionary stance quickly and effectively thereafter”.
He has also said that the government needs to lay down a road map for credible fiscal consolidation. The government has taken a huge risk in letting the fiscal gap widen to the extent it has. Finance minister Pranab Mukherjee has promised a quick return to fiscal discipline as well.
With the economy stabilizing and inflation due to rise, it is time to start talking about how to tighten monetary policy and cut the fiscal deficit.
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