Inflation vs growth: RBI’s choice is clear

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: When the Reserve Bank of India (RBI) unfolded the third quarter review of its monetary policy on January 29, most bankers were surprised that the central bank left key policy rates unchanged.

The RBI’s stand was even more of a shocker when major central banks like the US Fed and Bank of England recently slashed rates to boost their economies that slowed down due to the recent subprime mortgage crisis, estimated at a whopping $300 to $400 billion.

The mortgage crisis of mid-2007 has subsequently snowballed into a major liquidity crunch in developed economies such as the US, thereby forcing the central banks to make funds available at cheaper rates.

There have been various accusations hurled at the RBI for not lowering key rates when the global economy has been slowing down in addition to the domestic economy. Foreign institutional investors are now less inclined to increase their equity exposures on Indian bourses and have been pulling out funds systematically since this year. From January 16 to February 2, the data published by the Securities and Exchange Board of India reveals a net outflow of nearly Rs 15,000 crore.

FII inflows have nearly stopped and a section of the market is now worried.

They now believe that FIIs have withdrawn monies because India is no longer an attractive destination for overseas investors. But that was always hot money and never intended to stay permanently nor is it a sole barometer for growth.

Much more writing on the wall is needed to conclude a retardation in growth.

Many hedge funds and foreign banks, whose parent organisations have incurred huge losses on account of subprime credit losses in the US and other developed economies, are now repatriating funds back home and not on account of Indian equities being unattractive. Natural, as it seems they are following the market practice of profit booking and offsetting losses.

One of the key reasons for the RBI to leave key policy rates unchanged stems from the fact that it is not in a pre-emptive mode as much as that of remedying sickness after diagnosing the illness. Secondly, its single goal now is that of keeping inflation under check. The WPI for the week ended Jan 26 has already spiraled upwards of 4% to 4.11% from the previous week’s 3.93%.

Undeterred by the Federal Reserve rate cut— twice within a span of a week, the first being a 75 basis point cut on January 22 to 3.5% and the second on January 30 by 50 bps to 3% —the RBI governor told mediapersons after the policy announcement that its prime objective was that of curtailing inflation and keeping it below 5% levels. Its objective at the same time was to ensure stability through management of liquidity. Growth or a slowdown was not on the central banker’s immediate agenda.

This wasn’t the case with the Fed, as it was more into managing the tight money conditions there. Ditto for Bank of England that cut rates by 25 bps on Thursday.

Indian bankers initially were worried over the two Fed cuts and the widening interest rate differential that could lead to a few aggressive foreign banks raising cheaper money overseas and lending them here. The RBI is well in the know but has chosen not to act, at least for the moment.

The European Central Bank (ECB) too appears to have taken a cue from the RBI. On Thursday, ECB has done a similar act and left its benchmark rate untouched at 4% on Thursday.

Both the central bankers, the RBI and the ECB, have taken a similar stand—that of curbing inflation rather than supporting a weakening or slowing economy.

Fed and BoE, on the other hand, chose supporting a weaker economy through low rates.

The RBI, as one would realise by now, is focused on inflationary pressures caused by global oil prices and food prices. The government’s political stand of not passing on the oil price hike is making the task difficult for the RBI to curb inflation. The concern is more because consumer price index inflation is around 6% levels and the wholesale price index isn’t of much relevance. Taking these factors into consideration, inflation is more likely to pierce through the 5% target levels and could possibly rise another 150-200 bps.

Now, whether the central bank should support the economy or target inflation first is what bankers are hotly debating. The primary role of a central bank is to control inflation first and at the same time ensure there is adequate liquidity in the system to maintain growth. But that need not be always the case, given the Fed stand of lowering rates to boost growth that slowed down due to the subprime crisis.

For RBI, however, lowering interest rates or the repo and reverse repo do not take precedence at this point, and RBI governor Yaga Venugopal Reddy seems to feel that can wait at this juncture, unless growth figures turn dangerously negative. The recent data released by the Central Statistical Organisation that has predicted a slowdown in growth rate for 2007-08 to 8.7% from 9.3 % is disappointing indeed. But even at that rate the growth, as most economists say, is satisfactory. To arrive at an equilibrium as to which needs to be addressed first, inflation or growth rate, the RBI has opted to experiment with targeting inflation first.

This a deviation from the central bank’s stand in the early nineties, the days of early reforms that pushed up inflation as well as interest rates, following the rapid pace of growth. At this point, it is only when the actual growth figures are officially out for the current year, can the RBI take a stand on interest rates. The RBI could keep the rates same or even lower rates if there are clearer signs of a slowdown.

The bets are on a low interest rate regime in the next fiscal, beginning April 1. Why else are banks, especially government banks cutting rates now?