The former Federal Reserve chairman's tight monetary policy tipped the US economy into recession in the early 1980s, but succeeded in curbing double-digit inflation rates. Following in his footsteps, Raghuram Rajan raised the monetary authority's key policy rate by 25 basis points on Sept. 20.
Investors were shocked. Yes, inflation is high at 9.5 percent, but GDP growth is collapsing. Strip out government consumption, and real demand expanded only 1.4 percent from a year earlier between April and June. Combating the Indian stagflation with higher interest rates will mean an even bigger sacrifice of output. Stocks fell as much as 3 percent in Mumbai.
Yet, the central bank's focus on price stability is necessary. India's myriad state subsidies are inherently inflationary, as they pump cash into the economy without any commensurate increase in production. The federal budget deficit has reached 63 percent of the fiscal-year target in just four months. Recently announced spending cuts are unlikely to be enough to reduce the deficit in a stagnant economy.
Then there's the beleaguered rupee. To Raghuram Rajan's credit, he is reversing the ill-conceived defence of the Indian currency mounted by his predecessor Duvvuri Subbarao. Even while increasing the policy rate, Raghuram Rajan cut by 75 basis points the penal rate the central bank charges liquidity-starved lenders which borrow directly from it.
Subbarao's decision to jack up this rate by 200 basis points was ineffective. The rupee slid by 22 percent against the U.S. dollar between May and August. The higher rates did, however, raise the lenders' cost of financing long-term loans with short-term deposits and borrowings, effectively taxing a banking system already creaking under mounting bad loans.
Raghuram Rajan can hardly take success of his risky strategy for granted. The currency has stabilized for now, but another rupee slump will push inflation even higher by increasing the domestic cost of imported oil. And how much higher can Indian interest rates go before Raghuram Rajan's political masters stop him in his tracks After all, they have to face an election next year. Raghuram Rajan doesn't.
-The Reserve Bank of India, now helmed by Raghuram Rajan, a former IMF chief economist, lifted its key policy rate by 25 basis points on Sept. 20 to 7.5 percent to tackle near-double-digit consumer price inflation.
- Simultaneously, the central bank announced a 75 basis point reduction in the marginal standing facility (MSF) interest rate at which banks facing a liquidity squeeze borrow directly from the monetary authority.
- The RBI had raised the MSF rate by 200 basis points to 10.25 percent in July to shore up the rupee by triggering a sharp increase in short-term interbank interest rates.
- The rupee, which slumped 22 percent against the U.S. dollar in four months through Aug. 28, has erased half of its losses since then. The rupee traded at 62.13 against the U.S. dollar after the monetary policy announcement at 11:00 a.m. (0530 GMT) in Mumbai, down from 61.96. The benchmark National Stock Exchange Nifty index declined as much as 3 percent.
By Andy Mukherjee
(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)