Overuse of monetary tools can blunt their efficacy

Written by Shubhada Rao | Shubhada Rao | Updated: Oct 26 2011, 08:17am hrs
The second quarter review of the FY12 monetary policy is important from two perspectives one from the cyclical monetary policy side, and the other, from the structural regulatory front.

In consonance with its recent rhetoric of continuing with its antiinflation stance, the RBI hiked repo rate by 25 bps to 8.50%. The importance of Tuesdays policy comes not from the action, but from the guidance. Clearly while inflation was expected to remain sticky at elevated levels until November, the recent economic data has been increasingly pointing towards a sharper moderation in economic activity than earlier anticipated. Furthermore, the dominant growth driver, viz., private domestic consumption, was largely emanating from the expansionary fiscal policy and not through investments. With mounting pressure for fiscal consolidation, it had become imperative for the monetary policy to provide a guidance that would be conducive to spur investment growth.

The RBI has hinted at the possibility of no action in its upcoming mid-quarter review in December.

After adopting a more aggressive stance in hiking policy rates since May this year, the motivation for a pause in December has sprung from rising concerns on the domestic growth front amid a decline in sequential momentum of inflation.

With momentum indicators on inflation providing some comfort, RBI had the headroom to address the emerging growth risks. A sharper decline in growth would, in turn, make the task of fiscal consolidation more challenging as tax revenues would get adversely impacted.

Anchoring inflation expectations has been the biggest challenge for RBI as these elevated expectations have essentially emanated from the supply side, both domestic and global, viz. food and fuel. As such, household expectations have continued to remain elevated. This is because of rising food and fuel prices, which have a wider incidence and a greater recall value for households.

Statistical evidence suggests a significantly higher impact of the consolidated food & fuel inflation on household inflation expectations vis-a-vis core inflation. In this context, over-use of monetary policy instruments can blunt the efficacy of the policy tools in achieving the desired outcomes. A concerted policy action from the governments side is imperative to address structural imbalances and capacity bottlenecks to have a long-term impact on inflation expectations. The inflation trajectory is expected to move southwards, more emphatically from December onwards. We expect the evolving domestic and global economic scenario to obviate the need for further monetary policy tightening, though some near-term upside risk to inflation will prompt RBI to maintain status quo till Q1 FY13. On the regulatory front, the RBI made a landmark policy change by deregulating the savings bank deposit rate. From a monetary policy perspective, it will enhance the monetary policy transmission mechanism.

* The writer is president & chief economist, Yes Bank. Views in this article are her personal.