There’s a curious disconnect between what the Reserve Bank of India (RBI) says in its monetary policy statement and the meagre 25 basis points hike in the repo and reverse repo rates and in the cash reserve ratio.
In his statement, the RBI governor alludes to a host of reasons for worrying about inflation. He says that RBI’s quarterly survey of inflation expectations indicates that household inflation expectations remain at an elevated level. He points out that RBI’s industrial outlook survey shows that companies are regaining pricing power. The statement says that global commodity prices are firming up and could pose upside risks to inflation. It says that as the recovery gains momentum, demand pressures are expected to increase.
And after reciting this litany of woes, D. Subbarao adds the final touch, by asserting that “it is likely that structural shortage of certain agricultural commodities such as pulses, edible oils and milk could reduce the pace of food price moderation”.
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Yet, RBI has predicted 5.5% inflation in March 2011. Predicting inflation so far in the future is a mug’s game, as RBI knows well. In its April 2009 monetary policy statement, it had predicted inflation at 4% in March 2010. It came in at 9.9%. To be fair, though, RBI has this time drawn attention to three uncertainties: the monsoons, crude oil prices and the “evidence of demand pressures building up”.
If Wholesale Price Index inflation does actually come in at 5.5% in March next year, that’s still a bit above the repo rate of 5.25%. In other words, the real policy rate is still negative. Is it appropriate to have a negative policy rate when the economy is doing so well? Moreover, liquidity continues to be abundant. The average amount parked in reverse repos last week was around Rs50,000 crore. The CRR hike will withdraw just Rs12,500 crore of that.
The markets have reacted predictably to RBI’s lower-than-expected hike. Immediately after the announcement, the 10-year government bond yield dipped below 8%, while in the equities market rate- sensitive stocks bounced a bit.
Why, despite all that it has said about rising inflationary expectations, has RBI opted to do so little? Subbarao has been very candid about the reason. This is what he says in his statement: “Notwithstanding lower budgeted government borrowings in 2010-11 than in the year before, fresh issuance of securities will be 36.3% higher than in the previous year. This presents a dilemma for the Reserve Bank. While monetary policy considerations demand that surplus liquidity should be absorbed, debt management considerations warrant supportive liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that while absorbing excess liquidity, the government borrowing programme is not hampered.” In plain English, RBI is throwing up its hands and saying: yes, of course, there are inflationary pressures and we should probably do more about them, but what do we do, the government’s borrowing programme has to go through?
At the back of the governor’s mind is also the nagging thought that the first auction of the new fiscal had devolved. And this is the slack season when private borrowing is low and bank credit growth has just started to take off. When it starts to really grow, as demand picks up, the government borrowing programme will need even greater support. RBI has, in fact, made a very cogent argument for hiving off the debt management function from the central bank and housing it within the finance ministry.
Is RBI also worried that growth may be fragile? The policy statement says that the central bank is not so sanguine about the recovery in advanced economies, which means external demand could be weak. In its report on macroeconomic and monetary developments in 2009-10 released on Monday, RBI had pointed out that “alongside, calibrated exit from the expansionary fiscal and accommodative monetary policy stances, stronger pick-up in private consumption and investment demand would be necessary to sustain the growth momentum”. The same report also pointed out that while capacity utilization has been improving, it remains below the peak observed during the pre-crisis period. But then, RBI also says that GDP growth this year is likely to be 8%-plus.
If we compare the current recovery with the beginning of the last business cycle, the repo rate was 6% in April 2004 and the reverse repo rate 4.5%, both well above the 5.25% repo and 3.75% reverse repo rate at present. And average inflation during 2004-05 was 6.5%—it’s likely to be at least thereabouts this year too. What’s more, GDP growth in 2004-05 was 7.5%, lower than what RBI is projecting this year. Does it not therefore call for a higher policy rate? The problem is that this time deposit and lending rates are higher for the current stage of the cycle, the fiscal deficit is larger and the external environment is more uncertain. Companies have recently started to expand capacity and they will require funding. And, after all, where’s the hurry, headline inflation is going to come down. These factors may have reined in the central bank for the moment.
But it’s unlikely to stay its hand for long. As several economists have pointed out, RBI has a long way to go before policy rates get to their average level. It has only taken the first baby steps towards normalizing them.
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org