India is facing the prospect of stagflation. Output growth has slowed down sharply, and is below the recent long-run average of around 7% and consumer price inflation seems to be stuck at around 9-10% (see graphs).
What should RBI’s stance be in the forthcoming monetary policy meeting? Under the current circumstances, perhaps the best contribution RBI can make to India’s long-term growth is not to give in to the pressure for cutting interest rates, and steadfastly hang in there till inflationary expectations come down. This may happen a few quarters after consumer price inflation rates actually come down. If it moves now, this may not happen.
There is an increasing clamour for RBI to cut interest rates. The government has announced a series of reform measures as well as steps to cut the fiscal deficit such as cutting subsidies on diesel and LPG. Additional plans for disinvestment have been announced. With these and better tax administration, the government hopes to reduce the fiscal deficit. RBI has been making the case that the government needs to bring the fiscal deficit under control for inflation to come down. With the present expansionary fiscal policy, RBI would need to keep monetary policy tight to keep inflation under control. The government is now suggesting that it is doing its bit to control the deficit, so RBI must now ease monetary policy to kick-start investment and push up growth.
RBI Governor Subbarao has a difficult call to make. Considering that inflation has remained high and above RBI’s target rate of 4-5% for multiple years now, inflationary expectations have remained high. An easing of monetary policy at this stage will convey that a higher inflation rate is acceptable. This will keep inflation rates high as price setting, salary negotiations and contracts for the coming year will build in the higher inflation rate.
The biggest problem with the investment rate today is issues of government policy and implementation. Projects are stalled largely due to environment and forest clearances, availability of ores and minerals, which has become difficult due to mining bans or other processes that are under litigation or investigation, the difficulties of land acquisition, and the availability of power and water. The government is now setting up a National Investment Board that is expected to give clearances to all projects that cost R1,000 crore or more. Only when projects that are currently stalled due to these problems, bank loans that