Central bankers usually hold their cards close to the chest, preferring to keep markets guessing about their next move.
However, Reserve Bank of India (RBI) governor D. Subbarao seems to be trying to do things his way. He has publicly announced every major shift in his policy stance on interest rates over the past year, an unusual habit for a central banker.
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Subbarao clearly signalled in October 2009 that he would begin unwinding the loose monetary policy of the two previous years, as the Indian economy stabilized after the convulsions in the brutal aftermath of the financial crisis of late 2007.
He then announced in his monetary policy statement of September that the normalization of policy was over and future changes in interest rates would depend on the latest data for growth and inflation.
And Subbarao said on Tuesday that monetary tightening has ended for now, barring the need to act in response to some sudden domestic or global shock. “Based purely on current growth and inflation trends, the Reserve Bank believes the likelihood of further rate actions in the immediate future is relatively low,” the RBI governor said.
The central bank seems to have put down arms before it has busted inflation. This decision is a bit puzzling to anybody who has been keeping a tab on various speeches and reports emanating from RBI headquarters, especially the transparent concerns about inflation.
The latest statement from Subbarao effectively means that India’s operational policy rate will not go beyond 6.25% in the immediate future. Inflation measured by wholesale prices is still 8.6% according to the latest data, leaving real interest rates in negative territory. It has a long way to go before interest rates are higher than the inflation rate.
Core inflation based on the prices of non-food manufactured goods appears to have peaked and one can guess that the central bank expects core inflation to drop by at least a couple of percentage points in the coming months, but this hope does not quite fit into the worries expressed in recent months by various senior RBI officials about the persistence of high inflation in India. The review of the economy released by RBI on Monday was dominated by concerns about how inflation continues to be too high for comfort. The policy statement on Tuesday also highlighted the upside risks on the price front.
Also, global prices of crude oil and other commodities could flare up if the US Federal Reserve goes ahead with a second round of quantitative easing this week, with India importing this inflation.
Sustained high inflation has also changed matters on the ground. The inflation expectations of households tracked by RBI continue to remain at elevated levels, perhaps largely because of high food prices on which interest rate policy has little effect. These rising inflation expectations could fuel demands for higher wages in the coming months. Neither the data nor statements by RBI officials provide reason for sanguinity on the inflation front.
Yet, a temporary pause in monetary tightening has been signalled.
The central bank also has to ensure that growth stays on track. The Indian economy seems set to expand at around 8.5% in the current fiscal. What matters is where this growth will come from. The main driver is likely to be private consumption and investment demand, since external demand could be weak given the current state of the global economy and government demand will have to be capped if public finances are to be put in order. In other words, a lot depends on how much consumers spend and companies invest. A steep increase in interest rates from the current levels could choke off private sector demand, at a time when neither exports nor public spending can be depended on.
This situation could extend into the next fiscal year as well. The big policy challenge over the next year is how domestic demand is managed through a combination of fiscal policy and monetary policy.
All eyes should thus be on finance minister Pranab Mukherjee and his next budget.
India currently has an unacceptably high fiscal deficit. It needs to be trimmed. The extent to which the government can cut its fiscal deficit in February could impact interest rate policy. The more the government tightens fiscal policy, the more the space RBI has to keep interest rates close to current levels. However, if fiscal policy continues to be too loose, then the central bank will have to be more hawkish in its interest rate policy.
Subbarao has said that he is unlikely to raise interest rates in the “immediate future” without defining a precise time frame. One possibility is that it now makes sense for RBI to wait for the next Union Budget due in February before it makes any major move. So, it could be four months before the thumb is taken off the pause button.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at email@example.com