What should monetary policy do on July 28? If it is felt that the downturn is mostly over and the risk is that of inflation, then it is time to tighten interest rates. If it is felt that the downturn is mostly in store and the risk is that of a further decline in output, then it is time to cut interest rates. RBI?s challenge is one of utilising diverse pieces of information and making good-quality forecasts about inflation and output growth over the coming one year. This is a complex challenge and requires top-quality economists.
There are three pieces of evidence that favour the optimistic sense that the economy is on the mend. The first is the IIP, where the period of declining IIP, month-on-month, seems to have ended. The second is the CPI-IW that is showing month-on-month inflation of roughly 5%. The third is that the leading indicators of business cycle conditions in the US are now looking up.
The improvement in IIP can possibly be explained as a case of firms rebuilding inventories, compared with the period of the liquidity crunch where firms ran down inventory in response to difficulties in obtaining working capital. The CPI-IW has an inordinately high weightage on food prices and should hence be viewed with some mistrust. Many other indicators in the economy look gloomy.
The flow of new projects proposed in CMIE?s Capex database has stalled. Companies are executing old projects but the pipeline is not being refilled. Growth of capital goods production or imports continues to be negative. Exports continue to shrink. These facts add up to a picture of two negative shocks: a shock to investment demand and another shock to export demand. WPI inflation is roughly at zero percent. If this is the basis used for real rate calculations, then the short-term interest rate should be roughly at zero percent.
The real problem for RBI is the extent to which monetary policy considerations do not determine monetary policy. RBI?s decisions are constantly distorted by two kinds of compulsions. Sometimes, RBI as investment banker to the government distorts reserve money in trying to achieve the investment banking function. Sometimes, RBI as exchange rate pegger distorts reserve money in trying to trade in the currency market. In either event, these two extraneous impulses routinely distort RBI?s thinking, and interfere with the proper conduct of monetary policy. It would not be surprising if this time also, RBI?s decisions are not the decisions of a professionally sound central bank with a single-minded focus on executing monetary policy.
The author is an economist with interests in finance, pensions and macroeconomics