Mumbai: A day after the Reserve Bank of India (RBI) raised its key policy rates, deputy governor Subir Gokarn is confident that inflation could be capped at 6% by the year-end. According to him, the monetary policy transmission will work better when banks pass on the rate action to the consumers. Edited excerpts:
Balancing act: RBI’s Gokarn says the central bank expects softening of commodity prices in the rest of the year. Ashesh Shah / Mint
Why did you go for a 25 basis points (bps) hike in repo rate? Why not 50 bps?
If you are looking at a quarterly hike of 50 bps, we have actually done that. It’s just that we have split it up in two phases.
What we are doing is in accordance with our assessment of the situation. You need to take into consideration two factors. The first phase of our tightening cycle began with withdrawal of the ad hoc measures in October (2009). But more conventional instruments were used in January (2010). At that point, we were clearly in a situation where the domestic recovery itself was relatively early in its progress and it was difficult to predict that it would materialize as robustly as it has done.
The global situation while witnessing some improvement was still fraught with uncertainties and there was a lot of excess liquidity. So our logic was that we first needed to get the liquidity out before we could start to consider rate hikes. Meanwhile, domestic inflation started to rise. It shifted from food, which in any case was really not something we believed we could control directly, to other things very quickly. That was perhaps the motivation to hike rates earlier than when we had anticipated.
Once we started doing that, we felt, first, the recovery is still in its early phase and, therefore, a more drastic hike may pose risks to it. Secondly, the global scenario today is very different from what it was in 2007-08 when we were sort of overheated as was the rest of the world. Today, we are accelerating very rapidly, but the rest of the world is very sluggish. This is an environment in which moderate actions, from our viewpoint, is an appropriate approach.
Calibration does not mean that we don’t make the necessary changes. It’s really a question of having accepted the direction of policy, but to make judgements based on latest developments on the pace and the timing.
Can we expect one more hike on 16 September when RBI unveils its first six-weekly policy?
We have since 2005, moved from a biannual cycle to a quarterly cycle because we felt we needed more frequent announcements. The situation was dynamic and we were more globalized and,?therefore, more subject to external developments. That’s not a one-off process. This scheduling itself is something that is subject to constant review.
We have been doing mid-quarter reviews internally and we were debating for some time the merits of taking this, one step further and making it a regular feature. Instead of keeping it internal we thought (we) could share this with the public. So, essentially it’s a mid-quarter assessment that we will share. Whether it is a basis of action or not depends on the circumstances.
Do you have enough data for a mid-quarter review?
When you look at the six weeks, we have two monthly inflation numbers. We have two IIP (Index of Industrial Production) numbers; in some cycles we have a GDP (gross domestic product) number. We have also weekly inflation number for six weeks and the weekly credit growth numbers and all money market rates.
If you take a look at global developments, you will see how fast global perceptions have changed. From April-May, there was a very significant ratcheting down of the global outlook. That one month was a critical factor in terms of how the global recovery was perceived. Things change really quickly and that justifies a more frequent assessment even if it is not to the same level of comprehensiveness as the quarterly one. We will retain the quarterly process, but we will also do these shorter, more compact mid-quarter assessments.
You have said that you will not keep extra liquidity. Does that mean a rise in cash reserve ratio (CRR)?
No instrument is off the table. Our process started in January and we began by trying to extract liquidity through hikes in CRR. In May, there was still some surplus (liquidity), but at that point we wanted to wait and watch to see how the public finance situation was to evolve. By May-end, auction numbers were clearly far above our own expectations and we had an indication that there could be some liquidity mismatches. Once that materialized, we moved on to a different regime where we tried to balance the liquidity constraint with the monetary priorities. Eventually, we moved from the lower end (of the liquidity corridor) to the upper end. That enabled us to start focusing on rate hikes as a monetary instrument. But, if the situation is reversed and we were to see significant excess liquidity back in the system, clearly the management of liquidity will become a priority.
How confident are you of capping inflation at 6% by the year-end?
We have to go by information that we have as of now—performance of the monsoon and the IMD (India Meteorological Department) forecast are fairly positive. On this basis, we are confident that food inflation will moderate. We also expect softening of commodity prices in the rest of the year. Our actions in the first half of 2010 will start having an impact in the second half of the year. As of now, liquidity and credit conditions are such that the bankers will have no option but to start to pass on rate increases to the consumers. So, the transmission will improve and that should also help (in containing inflation). Forecasting inflation is not a very easy process and there is always a margin of error.
So you are open to revise the inflation projection again?
Obviously. To paraphrase the famous Keynesian quote “when the facts change, we change our minds. What do you do, sir?”
You want to review the current operating procedures of the monetary policy. Why?
There have been debates about the appropriateness of the liquidity corridor (the gap between the repo and reverse repo rates). If we have a corridor, what should be the appropriate width? What kind of instruments should be used to manage volatility within the corridor? How should we keep the rate at the mid-point as opposed to it being at the boundaries? We need to assess these issues once every few years.
If not real economy, it looks like monetary policy is decoupled from the world.
This is a reflection of the way the global economy has recovered from the crisis. Different parts of the world have recovered differently and monetary policy in each country has to respond to domestic pressures, but in the context of global conditions.