Dr Subbarao?s dilemma on Friday could well have been one straight out of an undergraduate macro economics textbook?what to do when growth looks good but fragile while inflation growls louder. His response has been quite decisive. By hiking CRR by 75 basis points, slightly above market expectations, while holding the policy rates constant, he has finally shown where RBI?s fears lie.
First, let?s take some monetary economics basics. The central bank, with its control on interest rates, can step on the brake or the gas to affect aggregate demand in the economy. Lower the rates, step on the gas that is, and investment and demand for credit, now available cheaply, will soar. This may lead to growth, or, under different circumstances, inflation. If there is slack in the economy, demand rise will lead to output growth, and in the current context this may help pull out of a slowdown. If the economy is near full-capacity or supply-constrained, the same demand rise will take it downhill into a recession.
Simple enough. The only challenge is that there you have to drive blind-folded. Further, add the fact that the car is not really as responsive as you initially thought. Hit the brakes and it may still skid into inflation, if worsening supply-side conditions are the real reason.
As the world collects itself from the crisis, the recovery seems global but stronger in the emerging markets where it is spurring capital inflows. At home, the second quarter growth of 7.9% exceeded expectations. While the monsoon partly failed and crop output is likely to suffer more, industry and services are showing smart recovery. Consumption has turned around, as has investment. Even exports have begun to rise while the fall in imports seems to be flattening out. All in all, there is a picture of strength, though the arrears of Sixth Pay Commission payouts and other fiscal components seem to be playing an important role and suggesting that the recovery is still not on firm footing without government help.
On the other hand, inflation and food prices have become increasingly uncomfortable. Most worryingly, the WPI and the CPI seem to be diverging, which means even the meters cannot be fully trusted. Food price rise is slowly spreading out to other parts of the economy, building up to a stage where inflation can well become self-sustaining. The transmission channel of interest rates to agricultural prices in India has always been rather weak, but unless RBI is seen to act decisively against inflation, the status quo may just feed the spiral of inflationary expectations across sectors.
The accommodating stance of monetary policy in the wake of the crisis has resulted in liquidity sloshing around, so much so that for better companies, sub-BPLR lending had become the norm. The real sector and financial sector disconnect had begun to grow.
Given all this, regardless of the noises made by industry lobbying bodies, it was almost inevitable that a tightening would have to happen, if only to send out a signal that RBI is serious about inflation. The industry expectation was a 50-basis-point rise in the cash reserve ratio (CRR).
In the event, Dr Subbarao went further?for a 75-basis-point change?reversing less than a quarter of the aggressive CRR cuts in the wake of the crisis. It may have surprised some, but it is difficult to disagree strongly with the decision. Between the suspected fragility of the rebound and the doubtless immediacy of burgeoning prices, the latter was clearly more threatening. The signal too needed to be decisive and visible, hence perhaps the extra 25 basis points.
The choice of the instrument is also significant. By leaving repo rates unchanged, RBI will probably leave the bank rates unchanged as well, at least in the short run. But excess liquidity from the system will be sucked away. Effective lending rates may change, but one is hard-pressed to see that the effect would squeeze out major borrowing. With returning FII flows and renewed markets rises, liquidity is unlikely to become scarce in the system.
What final result this would bring about in the real sector is difficult to say though. The continuation of the recovery may depend more on that of the fiscal measures and is unlikely to slow down because of the rate change. On the inflation side, food price rise itself will probably show little effect because of this particular move. If anything, it may impact pricing decisions in other parts of the economy, something always difficult to pinpoint precisely.
In any case, RBI is right in pointing out that for the remainder of 2009-10 it would be ?prepared to respond swiftly and effectively through policy adjustments as warranted?.
This is hardly the time to sit back and relax.
The author teaches finance at the Indian School of Business, Hyderabad