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RBI: hawkish statements, dovish action

The growth slowdown has been worse and the inflation data better than what RBI expected some three months ago; that could explain why D. Subbarao has continued to reduce interest rates despite the persistence of inflationary pressures. Photo: Abhijit Bhatlekar/Mint (Abhijit Bhatlekar/Mint)Premium
The growth slowdown has been worse and the inflation data better than what RBI expected some three months ago; that could explain why D. Subbarao has continued to reduce interest rates despite the persistence of inflationary pressures. Photo: Abhijit Bhatlekar/Mint
(Abhijit Bhatlekar/Mint)

The apex bank has been making hawkish statements but following up with dovish policy action. Why?

In his March monetary policy statement, Reserve Bank of India (RBI) governor D. Subbarao had reduced the key policy rate by 25 basis points, but warned “the headroom for further monetary easing remains quite limited". Private sector economists were quick to conclude that there would be few interest rate reductions in the fiscal year beginning in April.

The Indian central bank has continued to sound warnings about the Indian economy. Its economic review released on Thursday had a distinctly hawkish tone: it more or less repeated the message it sent out in March. The monetary policy statement released on Friday flashed the same signal once again: “Monetary policy cannot afford to lower its guard against the possibility of resurgence of inflation pressures. Monetary policy will also have to remain alert to the risks on account of the current account deficit and its financing…the balance of risks…yields little space for further monetary easing."

But Subbarao reduced the policy rate by another 25 basis points, nevertheless. One basis point is one-hundredth of a percentage point.

There is now a clear wedge between what the Indian central banks says and what it does. It had spoken like a hawk, but acted like a dove. It is not just a matter of interest rates. RBI has also been increasing the liquidity in the financial system through reductions in the statutory liquidity ratio and the cash reserve ratio as well as bond purchases as part of its open market operations.

The only way to explain why Subbarao has continued on this confusing path is by looking at what has happened to economic growth and inflation in recent months. Economic growth in fiscal year 2013 is likely to be at least 50 basis points below what the central bank had projected in its third quarter review in January. Inflation at the end of March was 80 basis points below the expectation of the central bank.

In other words, the growth slowdown has been worse and the inflation data better than what RBI expected some three months ago. That could explain why Subbarao has continued to reduce interest rates despite the persistence of inflationary pressures.

The governor has done well to reiterate the obvious risks that the Indian economy continues to face: a massive current account deficit that is increasingly being funded by unstable capital flows; a fiscal deficit that is being brought down, yet is way too high; the collapse in private sector investment; and the continuing risk of a wage-price spiral, especially in rural India.

Subbarao seems to have bet on the fact that lower international commodity prices, the loss of pricing power by local companies and the prospect of a normal monsoon will keep a lid on inflation till at least September, though inflation expectations continue to be in the double digits according to the latest consumer surveys.

Subbarao has been criticized for reacting too slowly to the inflation problem once the Indian economy bounced back from the post-Lehman downturn. RBI began tightening monetary policy around nine months after wholesale price inflation peaked. Loose fiscal policy has played a large part in pushing up inflation since early 2010, and massive increases in minimum support prices for farm produce had added to the problem. But the central bank’s critics also point out that it stayed behind the curve for far too long.

It is likely that RBI does not want to be caught on the wrong foot once again, and is hence moving more aggressively to loosen monetary policy than its own analysis suggests. Hence the divergence between what it has said and what it has done.

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