Home / Opinion / Online Views /  Economic conundrum leaves little luxury for RBI’s Subbarao

The Reserve Bank of India (RBI) has done what just about everybody expected it to do. It has cut the repo rate by another 25 basis points, which means that the Indian central bank has cut its key policy rate by a cumulative 100 basis points since January 2012. This monetary easing can be compared with the 375 basis points of rate hikes after inflation began to accelerate during the rapid economic recovery from the financial crisis.

That would suggest interest rates have a long way down to go, but central banking is not about such neat symmetry. Governor D. Subbarao has clearly indicated that he does not have much room left for significant interest rate cuts in the coming quarters. “Accordingly, even as the policy stance emphasizes addressing the growth risks, the headroom for further monetary easing remains quite limited," Subbarao noted at the end of the monetary policy statement.

The reasons for such caution are not hard to figure out. The Indian economy is growing well below its potential, and the trend in core inflation shows that companies are losing pricing power. Investment has collapsed. Consumer spending is also weakening, if one goes by the latest data on sales of cars and other consumer durables. Such a loss of growth momentum surely calls for lower interest rates in normal times.

It is not so easy. The fundamental problems are on the supply-side, especially the failure to create new production capacity to meet a rise in effective demand. A stimulus to demand at a time when the supply-side is rigid can only be inflationary, as India has seen since 2009. And while core inflation is now at a comfortable level, consumer prices are rising at double-digit rates. Food prices continue to soar.

Headline inflation is thus unlikely to drop in the coming months, for reasons well beyond the control of the central bank. “Headline inflation is expected to be range-bound around current levels over 2013-14 in view of sectoral demand-supply imbalances, the ongoing corrections in administered prices and their second-round effects. In addition, elevated food prices, including pressures stemming from MSP (minimum support prices) increases, and the wedge between wholesale and retail inflation have adverse implications for inflation expectations," said Subbarao.

The Indian economy is in a structural mess, with a growth collapse being accompanied by high inflation and a record current account deficit, which are both signs of excess demand. The previous time India saw such sluggish economic growth, around a decade ago, it had far lower inflation and a current account surplus, which had given RBI under Bimal Jalan far more scope for large interest rate reductions.

Subbarao does not have that luxury. The guidance he gave on Tuesday only reiterates this.

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