Opinion
Prudence wins the day: RBI didn’t go in for a knee-jerk rate cut
Summary
- By not deviating from its inflation focus, India’s central bank showed that it’ll go by what the economy needs and not what the government may want. That’s how it should be.
There’s something about the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) meetings that makes these the cynosure of all eyes. What stood out about the meeting that concluded on Friday, however, was not only the usual toss-up between growth and inflation.
Or the fact that it was the first after the government waded into RBI’s territory with first commerce and industry minister Piyush Goyal and then finance minister Nirmala Sitharaman making public statements on the need to cut policy rates.
Rather, it was the fact that it was the last MPC meet scheduled to be held under the chairmanship of RBI Governor Shaktikanta Das whose (extended) term ends on 10 December.
The unstated question on everyone’s mind was whether in the choice between supporting growth and fighting inflation, the MPC (or more correctly, the governor, since he has a casting vote) would veer towards the former, as desired by the government, or continue its ongoing fight against high inflation.
Would Das succumb to government and market pressure or stand by what has long become what seems like an act of faith with him? That the bank would “remain unambiguously focused on a durable alignment of inflation with the target, while supporting growth."
Also read: Mint Primer | Slowdown: Time to recalibrate India’s growth story in FY25?
That question was answered unambiguously by Das. The present growth-inflation balance requires the central bank to retain its vigil on inflation even as it keeps an eye on economic growth. No wonder the MPC voted by a 4:2 majority to keep the policy rate unchanged at 6.5%, as also the stance at neutral.
Prima facie, this might seem at odds with its sharply lower gross domestic product (GDP) growth estimate for the year—which it cut to 6.6% from 7.2% earlier—and marginally higher estimate for inflation, which it raised to 4.8% from 4.5% earlier. But as the governor clarified, “High inflation reduces the disposable income in the hands of consumers and dents private consumption, which negatively impacts the real GDP growth."
Sure, the economy had posted a tepid second- quarter growth of 5.4%, way below RBI’s October estimate of 7%. But if in the MPC’s assessment, “economic activity is set to improve along with rising business and consumer sentiments" and “the recent spike in inflation" reflects “continuing risks of multiple and overlapping shocks to the inflation outlook and expectations," there was no reason to cut rates.
It is understandable that the National Democratic Alliance (NDA) government wanted lower interest rates, as is usual with governments the world over when growth slows.
But differences between the government and central bank are inevitable, given their vastly different time horizons for policymaking. Governments in elected democracies live from one election to the next. Central banks, in contrast, have the luxury of looking at macro-fundamentals dispassionately.
Moreover, anti-incumbency, a familiar word in the world of politics, is a stranger to the world of central banks. The independence of central banks, whether de-jure or de-facto, as in India, means central bank governors can, and do, take decisions that are in the overall interest of the economy, regardless of whether it wins any brownie points with the government or not.
Though, to its credit, it must be admitted that the government has largely kept its counsel and respected the views of the central bank.
Also read: Five years is a long time to live with 4%-plus inflation. It can leave a bitter taste.
This institutional strength is not to be scoffed at. To ensure credibility of the inflation-targeting framework, inflation must be brought down; not merely because that is RBI’s mandate, but also because it is in the interest of sustained growth.
As Das put it, RBI remains “committed to restore the balance between inflation and growth and would use all policy instruments at its command to do so." It is hard to quarrel with the assertion that only with “durable price stability can strong foundations be secured for high growth," and this is best ensured by maintaining a status quo on rates while taking care that the liquidity needs of the economy are met.
The quarrel rather is with RBI’s preferred option of ensuring the latter through a reduction in the cash reserve ratio (CRR) or the percentage of banks’ demand and time liabilities that have to be kept with RBI at zero interest. Unlike open market operations, which allow RBI to adjust the quantum of liquidity in the market depending on the evolving situation, any change in the CRR is long-term in nature.
Even if one agrees with the governor’s assessment that liquidity is likely to be tight over the next few months for a variety of reasons (outflows for tax payments, increase in the currency in circulation and capital outflows), the merits of a CRR cut instead of liquidity-management through open market operations (OMO) are debatable.
RBI has always prided itself on its nimble-footed liquidity management. Resorting to a CRR cut weakens that claim. From the perspective of prudence and practicality, the same logic that argued against a knee-jerk reaction on rates should have argued against a CRR cut and in favour of the greater flexibility inherent in OMOs.
At least until inflation returns to that elusive 4% target and on a durable basis, given the distinct possibility that the US dollar will strengthen and the rupee weaken, with all its implications for higher inflation once Donald Trump takes office as president of the US.
Also read: Mint Primer | All about the inflation spike: how, why & when
