Reserve Bank of India (RBI) governor D. Subbarao will make his first monetary policy statement today. Events have overtaken him even as RBI has engaged in unprecedented monetary loosening. What should the bank do now?

Illustration: Jayachandran / Mint

At the moment, RBI is caught in a pincer: It’s injecting liquidity into the financial system and trying to “defend" the rupee at the same time. This is taking place against a background of continuing double-digit inflation, something that has mysteriously ceased to be a concern.

As a result, it faces a welter of confounding policy goals. If it does not defend the rupee, import bills will surge and in turn make inflation difficult to control. If it continues to stabilize the rupee by selling dollars (as it did on Wednesday, when it sold $2 billion), it erodes liquidity. This also undermines the effect of its 250 basis points reduction in the cash reserve ratio. This step had injected Rs1 trillion into the financial system. But, on the other hand, successive sale of billions of dollars has wiped out much of this liquidity.

It is being suggested that a policy rate cut is in order. As argued before in these columns, this should not be done in view of persistent inflation. The reasoning behind a rate cut argument is that as the global economy slows, commodity and crude oil prices are likely to come down and hence ease inflationary pressures. That may not happen. For example, in case of crude oil, the Organization of Petroleum Exporting Countries is mulling a production cut that is likely to harden oil prices again. Expected weakening of commodity prices is too fickle an assumption for a rate cut decision. In any case, no country defends its currency by cutting rates. The fall in the value of the rupee after the surprising 100 basis points repo rate cut on Monday shows the pitfalls of pursuing this course.

Another argument for a rate cut is that expansionary fiscal policy has run its course and hence monetary loosening is necessary if the faltering growth rate is to be arrested. Unfortunately, this view overlooks the problem of lending confidence that is responsible for freezing of credit. If the cost of credit has risen greatly, so has risk averseness. Banks are simply unwilling to lend. More loose money is unlikely to resolve that. There is little RBI can do to bring back that confidence. The challenge now is to attract capital to India, something that monetary policy can’t achieve. A rate cut at this juncture won’t do any good but will certainly cause more harm.

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