The decision of the Reserve Bank of India (RBI) to keep policy rates unchanged came as a surprise to the markets but more than that, the forward-looking guidance indicated that the central bank is quite keen to continue its anti-inflationary stance despite the recent growth slowdown.

Clearly, with headline WPI (inflation based on the Wholesale Price Index) starting to inch up and CPI (consumer price index) staying in double digits for two consecutive months, inflationary pressures in the economy can hardly be ignored. However, between the April and June monetary policies, the negative growth surprises were probably larger than the upside surprises on inflation. This created an expectation in the market that the bias of monetary policy might tilt towards supporting growth.

RBI is worried that at this juncture interest rates will be ineffective in stimulating growth because the economy is constrained by other supply side factors. There are two asymmetric policy responses inherent in this approach. First, relatively tight monetary policy can bring down growth and, in turn, impact inflation, while easy monetary policy might not be growth supportive. Second, in a tightening cycle, the first impact of monetary policy falls on growth and then on inflation, while on the easing cycle, there are risks of inflation moving up before growth responds.

Another theoretical issue arises out of the real interest rates. RBI mentions that the real lending rates are lower than the pre-crisis years and hence monetary policy is not too restrictive.

One wonders whether there is a possibility that economic agents in India get swayed more by nominal interest rates rather than real interest rates. If this hypothesis is true, then higher nominal interest rates can keep the investment sentiment depressed and the growth slowdown can be prolonged.

A healthy debate also needs to be undertaken to find out the impact of the rupee depreciation on the economy. In the June policy, RBI mentioned that the rupee depreciation can act as a “demand stimulus" in the long run. It is something which all of us have read in theory but again its efficacy is yet to be conclusively proved in the Indian context. In fact, if rupee depreciation is an expansionary tool, then will it be used as a policy instrument in the future.

The conventional wisdom is that the cost-benefit analysis of currency depreciation is difficult to undertake in the Indian context because of complex production matrices and uncertain lags. Particularly in the context of a slowing global economy, export growth might not respond immediately to currency depreciation for exporters with limited pricing power.

Sustained high inflation is surely an obstacle to growth. However, for better understanding of monetary policy dynamics, we need to focus on the right measure of inflation. The debate between whether monetary policy should target core inflation or consider headline inflation is a difficult one. Till the April policy, it seemed that core inflation was looked at more closely but in the June policy statement headline inflation has regained importance. Also, retail inflation, as reflected in CPI, has also been pointed out as a worrying factor. We think that often the same structural constraints that are likely to thwart the effect of any interest rate cut on growth are also responsible for the headline inflation remaining high. In that sense, the impact of tight monetary policy on headline inflation might be uncertain and we might remain in a high headline inflation, high interest rate environment for a long period of time.

There is no denying the fact that supply side measures are required to ease inflationary pressures in the economy and provide the necessary growth impetus.

However, as long as those measures are delayed, how monetary policy is going to nurture the economy such that growth momentum is not completely lost while inflationary pressures are under check is going to be the critical question. The monetary policy statement, and our assessment that in the near-term headline inflation will stay elevated, indicate no policy rate cuts. At best, markets can hope for a relatively comfortable liquidity.

Samiran Chakraborty is head of regional research, South Asia, Standard Chartered Bank.

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