Mid-quarter review of Monetary policy, 2012 - Over to you, Mr. Finance Minister 

Central bankers across the world face a tough choice between maintaining inflation in acceptable limits and growth. For the Reserve Bank of India (RBI), the equation becomes even more complex due to the country’s emerging economy status, its rapidly evolving market scenario and delay in policy reforms. RBI’s recent mid quarter review of the monetary and credit policy — the first one in FY13 — further highlights this anomaly. Despite a lot of expectations to reduce the short-term interest rates (repo rate) and/or cash reserve ratio (CRR), RBI decided to maintain the status quo.

Expectation of a rate cut were even stronger in view of the fact that the RBI reduced the repo rate by 50 basis points (bps) to 8 percent in its annual monetary and credit policy review in April, 2012. This was perceived to herald a trend of gradual monetary easing¹.

Some of the key reasons cited for RBI’s decision are as follows:

• Decline in growth rates not due to high interest rates: The estimated economic growth has declined to a low of 5.3 percent during fourth quarter of FY12 (6.5 percent in FY12) and the Index of Industrial Production (IIP) increased marginally by 0.1 percent in April 2012 ^2,3. However, the manufacturing Purchasing Managers’ Index (PMI) for May 2012 indicated expansionary industrial activity⁴. Further, According to the CMIE, none of the shelved projects worth INR 2,861 billion are as a result of high interest rates but predominantly due to policy-related hurdles (such as those related to land buys and environment-related issues).
• No fiscal consolidation: The RBI has been quite categorical in indicating that reducing policy rates has to be supplemented with concrete action by the Government towards— fiscal consolidation, easing supply-side constraints and reviving the investment climate in the country. With President’s election around the corner, the main agenda for growth keeps getting deferred.
• High inflation: Despite a consistent increase in repo rates during March 2010-April 2012, headline wholesale price index (WPI) — based inflation rate has not exhibited a consistent decline. Although it moderated from a peak of 10.0 percent in September 2011 to 7.7 percent in March 2012, according to provisional data, it increased from 7.2 percent in April, 2012 to 7.6 percent in May, 2012. Inflation based on the consumer price index (CPI) for industrial workers has also increased from 5.3 percent in January 2012 to 10.2 percent in April 2012 after declining in 2011⁵. Reasons for this rise could vary from scanty rain, high oil prices and government’s inaction on supply bottlenecks.

RBI has not been alone in grappling with the complex equation of growth and price stability. China’s central bank, People’s Bank of China (PBC) tamed the inflation through a series of rate increases – from 5.31 percent in October 2010 to 6.56 percent in July 2011 – which helped reduce CPI inflation from 5.09 percent in November 2010 to 3.03 percent in May 2012. It was only when the inflation remained below the comfort zone (of 4 percent) consistently for four months (February−May 2012), PBC proceeded with rate cuts in June 2012, from 6.56 percent to 6.31 percent. This also ratifies the cautious stand the RBI has taken in the policy review^6,7.

Brazil, on the other hand, has essayed a different story. Here, a gradual cut in interest rates was accompanied by a reduction in the inflation. The Banco Central do Brasil, the country’s central bank, cut the Selic interest rate from 12.5 percent in August 2011 to historical lows of 8.5 percent in May 2012. The period also witnessed a decline in CPI inflation, from 7.31 percent in September 2011 to 4.99 percent in May 2012. What worked in Brazil was that the central bank used regulations to directly reach the credit channel to spur economic growth. It is expected to improve monetary transmission, making even a small reduction in rates effective⁸.

RBI has clearly highlighted its independence in framing the monetary policy and has handed over the baton of responsibility to uplift the economic growth to the Government of India. It expects the Government to take strong measures to address the structural issues of supply-side bottlenecks and take the road to fiscal consolidation—Deregulation of diesel prices, reducing subsidies on oil, fertilizers and food and reducing its wasteful expenditure are some of the keenly awaited steps to achieve fiscal consolidation. Some of the much-awaited reforms such as amendments to the Banking Regulation Act, Pension Bill, Goods and Services Tax and Direct Tax Code are enough to restore investors’ confidence in Indian economy and put it back on the growth trajectory. It is time for the Government to act now.