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Business News/ Opinion / RBI’s job is done, ball in govt’s court
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RBI’s job is done, ball in govt’s court

The ball is now squarely in the government's court to create the conditions for the economy to embark on a non-inflationary recovery

Photo: ReutersPremium
Photo: Reuters

What next? Although this question inevitably crops up after each central bank policy announcement, the question is even more relevant at this juncture. Having delivered a cumulative 75 basis point rate cut in a span of five months, what should the Reserve Bank of India’s (RBI) optimal policy stance be going forward? (A basis point is one-hundredth of a percentage point.)

Views are mixed. Although some believe that not enough has been done, we believe that RBI should now stand pat as its job—of curbing inflation in 2013-14 and then minimizing the growth sacrifice in 2015—is now done.

There are long lags in policy transmission. Studies have shown that interest rate changes affect growth with a lag of two-four quarters, which then influences inflation. Therefore, even as there may be frustration with the current pace of economic recovery, more time needs to be given to judge the full impact of the rate cuts delivered thus far. Policy should not overreact.

This wait-and-watch stance will also be prudent because while India’s external sector is significantly less vulnerable compared with 2013, the country has received substantial portfolio debt inflows in the last year and some caution is warranted ahead of the reversal of US monetary policy.

Growth is set to recover, albeit gradually. India’s growth cycle has already bottomed out and now appears to be in the initial stages of a business cycle recovery. The impact of easier financial conditions, lower inflation, higher profit margins and faster policy approvals on growth are yet to materialize. As growth revives and the output gap narrows in the next year, the impact on inflation needs to be ascertained.

Of course, this growth uptick is largely cyclical. For potential growth to improve, investment and productivity need to accelerate, and RBI’s role here is quite limited. In contrast, the government’s role in removing bottlenecks to investment and trudging ahead on reforms lies at the front and centre.

Inflation has fallen sharply in the last year, but it is important to differentiate between the cyclical versus structural factors as weak growth, falling commodity prices and lower minimum support prices have all played a part.

Nomura’s analysis shows that lower oil prices have contributed about 35 basis points to lower year-on-year Consumer Price Index inflation. Lower minimum support prices have contributed 65 basis points, while another 40 basis points is due to the negative output gap. This implies that if the benefit from lower oil prices fades and growth goes back to trend, then the underlying trend in inflation will be between 5.5% and 6%, instead of around 5% currently.

This is not to say that inflation will spike; we do not think it will as long as macro policies are prudent. But it does mean that much of the inflation fall is still cyclical. That also explains why farm incomes are under such stress.

To make the inflation fall more secular, both the government and RBI have their work cut out. The government needs to embark on large infrastructure investment, eliminating the inefficiencies in the supply chain, boosting agricultural productivity, continued fiscal consolidation and resolving factor market bottlenecks. And until the supply side catches up, RBI’s role is to keep cyclical inflation pressures at bay and bring down inflation expectations on a sustained basis.

Sceptics argue that bank balance sheets are stressed and aggressive rate cuts are essential to ease the stress and get the economy revving again. Indeed, monetary policy has historically been the short cut to paper over the necessary secular adjustments, but that has also resulted in boom-bust economic cycles, instead of macro stability.

Overall, because of the lags in policy transmission, signs of a cyclical recovery, still-elevated inflation expectations and the supply side yet to catch up, prudence calls for RBI to take a bow now.

The ball is now squarely in the government’s court to create the conditions for the economy to embark on a non-inflationary recovery. As supply catches up, it may open up more space for RBI to lower rates in the medium term. But for now, we think RBI’s job is done.

Sonal Varma is executive director and India economist, Nomura Financial Advisory and Securities India Pvt. Ltd.

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Published: 03 Jun 2015, 12:41 AM IST
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