A combination of stubbornly high inflation and slowing growth can pose a dilemma for most central banks. Only those with a single-minded focus on keeping inflation in check are immune from other concerns. The Reserve Bank of India (RBI) has single-handedly shouldered this burden in the last 19 months. All this while, the government kept its spending taps fully open.
Finally, on Tuesday, the Indian central bank “revised” its policy stance. It raised the repo rate by 25 basis points (bps) to 8.5%, even as it hinted that this may be the peak of the rate mountain. RBI governor D. Subbarao said as much: “The likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted. However, as always, actions will depend on the evolving macroeconomic conditions.” In other words, it has a jemmy in its hands, even if it is kept away from the view of markets.
Cumulatively, the central bank has raised policy rates by 525 bps since March 2010 and now the repo rate is only 50 bps short of the pre-2007-08 crisis level of 9%.
The fact that RBI chose to raise the repo rate while being aware of an uncertain global economic environment and adverse domestic trends should make the government sit up and rethink not only its policy choices, but also its policy world view. Subbarao highlighted many of these problems when he hinted that in the medium run, inflationary pressures will continue to haunt the Indian economy: “Structural imbalances in agriculture, infrastructure capacity bottlenecks, distorted administered prices of several key commodities and the pace of fiscal consolidation combine to keep medium-term inflation risks in the economy high.”
The bank is clearly aware of the much restricted policy space in which it finds itself. The question is when will the government display a similar sensitivity? All our policymakers have done in the past 19 months is to issue statements that game theorists dismiss as “cheap talk”. Ideally, it should aggressively limit spending and help the central bank check inflation. At the same time, it has plenty on its hand to do on the supply front. It is unlikely to do either job properly.
With a general election due in 2014, it still has one year—until 2012-end—to go in for aggressive fiscal consolidation before it goes in for a pre-election year spending binge. In theory, this would be a bad policy, for it would bequeath high inflation to the next government. But given the recent performance of the government, even limited respite from inflation in 2012-13 is unlikely.
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