Govt should complement RBI's efforts

Revival of domestic growth is no doubt very critical; however, recovery in growth without attaining macroeconomic stability cannot be given a priority - The Mid Quarter Monetary review of the Reserve Bank of India (RBI) on September 20 - led by the new RBI Governor Raghuram Rajan had just indicated that.

High inflation, high current account deficit and volatility in the financial markets threaten to impact the macroeconomic stability of Indian economy.

The current scenario of rising inflation amidst significant slowdown in growth has rendered the monetary policy management quite challenging.

The RBI had to balance on a thin line between growth and inflation.

 However, by hiking the repo rate which has been contrary to market expectations — the Central Bank has clearly showed its inclination towards anchoring inflation and inflationary expectations. The Indian economy continues to traverse across a rocky road.

Gross domestic growth (GDP) growth has dropped to a 17 quarters low during the first quarter of financial year 201-14 and demand has weakened considerably. Nevertheless, the argument that easing of interest rates will support growth by stimulating the investment scenario is not clear as many projects are stalled or are not initiated primarily owing to delayed project clearances and regulatory hurdles and not due to high cost of funding alone.

However, low and steady inflation is a necessary pre-condition for sustained growth, the absence of which cannot provide a strong platform to support the growth dynamics.

 Inflationary pressures remain high (upside risks to inflation remains high owing to incomplete pass-through of significant rupee depreciation) and inflationary expectations remain entrenched. Moreover, rise in food and fuel prices which has a potential to spill over to the core inflation also poses upside risks to the overall inflation.

According to the RBI “the current assessment is that in the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year”.

The risks to macroeconomic stability from external sector imbalances had been increasing over time, more recently, since the US Federal Reserve’s indication to taper its monetary policy which posed significant risks to overall growth prospects.

Financial markets remain turned volatile and remained vulnerable to a large extent over the development in the external environment.

Moreover, it has been four years that the current account deficit (CAD) had remained well above 2.5 per cent.

Following which the RBI and the government had taken a number of measures to support rupee, contain the current account deficit and improve the environment for external funding.

However, some of the measures had been aimed at tightening the liquidity conditions at the short end of the term structure which had restricted the financial flows to the economy.

However, with growth momentum so weak, these exceptional measures cannot remain forever.

Some improvement in external environment, narrowing of trade deficit, stabilization in rupee given the US Federal Reserve’s decision to continue its monetary stimulus, diplomatic resolution in Syria had provided the backdrop to the monetary policy decision.
However, with growth momentum so weak, these exceptional measures cannot remain forever. Some improvement in external environment, narrowing of trade deficit, stabilization in rupee given the US Federal Reserve’s decision to continue its monetary stimulus, diplomatic resolution in Syria had provided the backdrop to the monetary policy decision.

The twin measures of an MSF (marginal standing facility) rate cut and a rise in the repo rate during the recent Mid-quarter Monetary Policy review could loosen short term liquidity conditions while at the same time keep interest rates high.

The lowering of MSF rate (real effective policy rate) by 75 basis points could marginally reduce the overall cost of funding for banks and also correct the inverted yield curve, thereby encouraging investments in longer-term instruments. For the time being, the rupee and inflation trajectory would be the key determinants of future monetary stance.

The MSF rate could witness further cuts when normalcy returns to the foreign exchange market. The upside risks to inflation remain high and the RBI is likely to remain in the cautious mode in order to keep a grip on inflation. The pass through of fuel prices and currency depreciation could prompt another round of repo rate hike by the RBI so as to keep inflation and inflationary expectations at bay.

Moreover, the RBI’s emphasis on CPI inflation (which has been sticky at around 9.5%) also portends a protracted monetary tightening.

 A good kharif harvest and the associated moderation of food prices could provide some elbow room for policy action in the reverse direction.

However, concerns prevail given that the Federal Reserve had just postponed its withdrawal of monetary stimulus. Such an action, as and when it happens, is likely to impact the rupee and global crude oil prices, and thereby inflation.

Fed’s deferment has in fact provided the Government and the RBI the time to undertake the required pre-emptive policy actions to counter the likely impact on rupee.

(The author is senior economist, Dun & Bradstreet India. Views expressed are personal.)