Too timid, RBI

Slash the fiscal deficit to fight prices

The most charitable view on the Reserve Bank of India's third quarter review of monetary policy would be that it trusts the government now to hike tax collections, curb expenditure and slash the fiscal deficit, so that monetary policy can chug along without signaling an urgent need to change.

After waxing eloquent about why inflation is 'clearly the dominant concern' - the baseline (emphasis added) projection of inflation for March 2011 has been revised up sharply to 7.0% from 5.5% earlier - the Bank fails to follow through with tough action.
It settles, instead, for more of the same: a 25 basis points hike in the both the repo and reverse rate (at which the RBI infuses and withdraws liquidity from the system). The Policy actually builds up a case for strong action. The year-on-year growth in non-food credit at 24% is above the RBI's projected rate of 20%.

The incremental credit-deposit ratio at the end of December 2010 is 102%, up from 58% last year. The economy is operating close to its trend rate of growth. The current account deficit for the fiscal, a likely 3.5% of GDP, is termed unsustainable. The bank's latest survey shows households' inflation expectations remain elevated.

There has been a substantial increase in prices of several food items even though their production has not been affected (showing rising demand even as production is stagnant). High global food prices pose an additional risk to domestic food inflation. Persistent food inflation 'cannot but have some spillover effects on generalised inflation, particularly when the growth momentum is strong. In the absence of commensurate increase in capacity there is the risk of demand side pressures accentuating.'

Yet after all this, the Bank fails to act tougher. It develops cold feet and settles for a tame 25 basis hike in policy rates and extends liquidity support measures that were set to expire later this month. This is unfortunate. The dominance of the fisc over monetary policy means the latter must often tighten harder-than-warranted in order to rein in inflationary expectations.

This is what Dr Rangarajan, governor of the RBI in the mid-1990s, did when he raised interest rates sharply. He was pilloried for it then but today few dispute that his tough action laid the ground for the long period of low interest rates, inflation and high growth that followed.(Source: Economic Times,26 January, 2011)