The Reserve Bank of India’s annual monetary policy statement released on Tuesday was met with a collective sigh of relief: the tightening was to a far lesser extent than had been anticipated.
Illustration: Jayachandran / Mint
The general apprehension was that RBI, out of concern that the economy may overheat—because capacity or supply has simply been unable to keep pace with the growing aggregate demand— would respond by raising interest rates. While the central bank did unambiguously signal its concern for inflation, it offered a palliative—an increase in interest rates by only 25 basis points and hike in the cash reserve ratio (CRR) by a similar margin.
By doing so, it seems to have bet on growth over inflation. This is similar to the assumption finance minister Pranab Mukherjee made in his Budget for 2010-11. In that sense, the finance minister and the central bank governor are on the same page, which is both good and bad. Good, because it is important, given the uncertain environment, for a country to have and articulate a unified policy response. Alternatively, if both the governor and the minister have misread the tea leaves, then the macroeconomic damage would be far worse.
The logic of RBI’s gamble is not difficult to comprehend. Without growth, tax revenue will dry up and funding the government’s vastly ramped-up expenditure programme will become next to impossible, at least not without letting go of fiscal restraint which, in turn, will stoke inflation.
RBI’s decision has been made easier because the finance minister made the right noises on fiscal correction during his budget speech and has committed to sticking to the path prescribed by the 13th Finance Commission.
The bank’s moderate moves might also be the best, given the circumstances. After all, no one seems to be able to explain the current bout of inflation. Policymakers have held forth how the phenomenon will be short-lived, yet the inflation rate has only accelerated and is now poised to scale double digits.
If you can’t identify the cause of the ailment, it is best to continue with symptomatic treatment in the medium term. It is far less dangerous than prescribing the wrong palliative. The central message of the monetary policy review is that the central bank is holding its nerve, preferring to err on the side of caution. It could do far worse.
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