Views | Not much room for RBI to cut rates

Views | Not much room for RBI to cut rates

Hopes that the Reserve Bank of India would go in for significant reductions in its key policy rates to fight the slowdown are rapidly diminishing. The March inflation numbers released on Monday, a day before governor D. Subbarao unveils his new monetary policy, in no way change the situation.

The key to the monetary policy debate is the output gap, a measure of how the economy is expanding compared to its potential. India has been suffering from high inflation because of a wide output gap that built up after around 2005, and recent research from the Asian Development Bank shows that India is even now growing only a bit slower than potential, thus capping the potential for deep rate cuts. (see chart)

What is even more worrisome is that the potential growth rate itself has drifted downwards since 2008, by around 1.5 percentage points. This means that India cannot grow at more than 7% a year without unleashing inflation. The potential non-inflationary growth rate was around 8.5% before the global financial crisis.

The blame for this loss of economic momentum squarely falls on the government. The disinterest in economic reforms as well as the regulatory tangles that have choked off private investment activity is now hurting. Loose fiscal policy has added to the problem, providing a boost to consumption when the crying need is for higher investment. I have argued several times in the past that what India needs right now is a healthy dose of supply-side economics led by reforms and better fiscal discipline.

Subbarao has to make his choices in this complicated situation. His critics already accuse him to moving too slowly to hike rates after the economy stabilized in late 2009, thus proving room for inflation to accelerate. He could in future be held responsible for keeping the cost of money too high in the midst of an investment slump. It’s not a good position to be in. But it is hard to see how the governor can steer the economy through these troubled waters unless he gets policy support from New Delhi.

Also Read | India needs a dose of supply-side economics