Banking on hope

While increasing the repo rate by another 0.25 percentage point to 8.5 per cent, the Reserve Bank of India has stuck to its harsh monetary stance for the 13th time since March 2010, but has indicated that this is possibly the last of the hikes. It expects inflation to start declining by December this year and reach 7 per cent by March next. The full impact of the bank’s efforts to curb inflation will be seen only in the coming few months because monetary impulses travel very slowly through the economy. But the negative impact on growth has already been clear and the RBI seems to be defensive about this. In earlier policy explanations the bank was unapologetic about its hawkish stance but this time it has said that it is aware of the cost in terms of slowing economic growth.

In defence of its consistent policy, it has the argument that a premature withdrawal might have been counter-productive. It had to stay the course for lack of a better option and because inaction would have meant worse for the economy. Even now its hopes of moderation of inflation in the December-March period seem to be too optimistic. There are favourable  factors like the good monsoon and the fall in prices of commodities due to the problems in the Eurozone, though the positive effect of the latter may somewhat be lost by the depreciation of the rupee.

The bank also probably took a cue from the actions of apex banks in countries like Brazil, Russia and China which have either stopped increasing or even started cutting rates.  Monetary measures can work best in a congenial policy environment created by the government. The bank has drawn attention, as in the past, to the responsibility of the government in containing inflation. The runaway fiscal deficit, the government’s tendency to overspend and borrow, failure to deal with supply side factors that cause inflation and inaction on the reform front have been major factors in keeping the inflation rate high.

The bank has lowered its growth estimates from 8 per cent to 7.6 per cent for the current year. The latest data on factory output and the slowdown in investment and corporate spending are clear signs of that. If inflation starts coming down, it may have to reverse its monetary stance quickly. The next two months will be a transitional period which will be crucial in the inflation versus growth debate.