Early warning systems must to ensure stability

Written by NR Bhanumurthy | Updated: Apr 29 2008, 01:54am hrs
It is said that the Reserve Bank of Indias priority is to achieve growth with price stability and ensuring credit availability to the needy sectors. In the last mid-term review (January 29, 2008) of the Credit Policy, the RBI talked of its emphasis on price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum. In other words, the RBI feels that it has the ability (or instruments) to anchor inflationary expectations without derailing the current growth momentum. Further, the mid-term Review also admits that there are unusually heightened global uncertainties that can cause instability and need unconventional policy responses.

But, since the mid-term review, the economic situation seems to be unfolding not on the RBIs predicted lines. Inflation, which the RBI wished to contain close to 5% by the end of 2007-08, has crossed 7%. This has mounted pressure on both the

RBI and the finance ministry to take necessary steps to control inflation in the medium-term. Given this situation, the markets were expecting a tight

monetary policy in the forthcoming annual statement. But, last week, the RBI hiked the CRR from 7.5 to 8%, indicating that there are inflationary expectations in the economy.

On the growth side, there are some downward risks given the high inflation, interest rates, and increasing world oil prices. The recent industrial output growth trends also indicate a moderation happening in the overall economic growth. Hence, the year 2008-09 is expected to see an uncomfortable inflation with slowing output growth. At this juncture, the question is: what should the RBI do After the hike in the CRR, what is left in the Credit Policy Can it stimulate growth

It is well understood that the current high inflation is being caused largely by supply side constraints after the rise in the world energy and food prices. A large part of it is imported and this is expected to be transitory. Hence, the monetary policy has very little role in controlling this inflation, as this is not due to demand side factors. Further, the full impact of the monetary policy on inflation will be felt after a significant lag of at least one year. Therefore, neither the recent CRR hike nor any change in the coming monetary policy is expected to mitigate inflation in the short-run. It will offset inflation only in the long-run. In other words, it is inevitable that we will live with the present inflation for some more time even at the cost of a little slowdown in the output growth.

But the reality is, any tightening of the monetary policy would hamper growth and prolong inflation. This is especially so because, until recently, many economists were suggesting a cut in the interest rates following a downward movement in the international interest rate cycle. So, given that its objective is to achieve growth with stable prices, it would be appropriate for the RBI to keep the interest rate structure unchanged for the time being. A more appropriate policy action could be to allow the exchange rate to appreciate, liberalise the capital account further or allow a portion of the reserves to fund infrastructure projects so that it reduces excess liquidity in the system and, thereby, minimise inflationary expectations in the medium-to long-term.

As the RBI rightly said in the last review, there are global uncertainties. Given the fact that the Indian economy is increasingly integrating with the global economy, this could hamper domestic output through a drop in global demand. Therefore, it is necessary for the RBI to strengthen the domestic fundamentals, create internal demand to counter the adverse impact of an expected slowdown in global demand. The present situation also warrants the RBI to work on early warning systems that mitigate risk and ensure economic stability. This is important, more so when neither the RBI nor the government had anticipated this present high inflation level.

There is a need for coherence and consistency among the policy makers to address issues like inflation and growth. We cant have an aggressive export policy with fiscal sops and a weak rupee when the cost of imports (particularly of crude oil) is skyrocketing. We cant afford to ban futures trading when they are supposed to be providing early warnings about the future risks.

The writer is associate professor, Institute of Economic Growth, New Delhi