R (unning) B (ehind) I (nflation)? NOT YET!

“Do you have any idea what potato prices have become....it’s now twenty three rupees a kilo! It’s hard to imagine that they used to once come for eight to ten rupees!” my father commented while trying to balance the plate passed on to him during dinner. Now I am not quite sure what small talk the RBI governor D Subbarao indulges in during dinner time, but I am quite confident that he too must be sharing my father’s concern for that rising CPI graph that refuses to be tamed!

Not surprisingly the run-up to the much touted Second Quarter Review of the RBI’s monetary policy was occupied by discussion on how it planned to tackle inflation. The famous debate in economics between growth and inflation once again claimed limelight. Would the RBI increase interest rates to quell inflation? RBI’s answer this time was, “No, but we have it in mind.” Much to the relief of industry captains, the key policy rates remained unchanged at previously benign levels while the SLR requirement was nudged back to its pre-crisis level of 25%. The other policy decisions taken by RBI (like doing away with refinance facilities) were similarly cosmetic in nature; all indicating that the RBI was shying away from any affirmative roll-back of its monetary prodigality this time around; but was signalling of stiffer action to come.

But why did RBI have to increase SLR? Well of course it is a step towards containing liquidity, but the fact remains that most banks are currently satisfying their SLR requirement comfortably; as a matter of fact they are exceeding it. A minor rectification of this ceiling is really not of much consequence to them. One might argue that it is a signalling device for tougher policy later. But again, why does the RBI need that? The moot question is: What would have happened if the RBI had not indulged in these token policy measures now, and directly attempted to target inflation by raising policy rates later?

The crucial missing piece of the jigsaw is that the RBI is really not interested in targeting inflation now. What the RBI is really concerned about in this review; is ‘expected’ inflation. And there is an important reason behind this concern. If people perceive a lethargic central bank that does not seem to worry about inflation, they would revise their expectation of inflation upwards in the coming months. This would in turn lead to the hoarding of commodities since people would expect prices to escalate. However paradoxically, this very action would lead to an upward spurt in the spot prices of commodities. Hence ultimately the same inflation that people ‘expected’ to materialise in a few months would in turn end up haunting them immediately.

Hence the RBI understands that howsoever superficial may be its policies in this review; some good marketing is necessary! People need to have cause to believe that the RBI is going to take proactive action, and that there is not going to be the case of a runaway inflation. And this feeds into a virtuous cycle since the RBI in turn requires this perception for its policies to succeed. Or else it would be grappling with inflation on a week-to-week guerrilla basis!

However the larger question is that instead of indulging in this charade, why didn’t the RBI in the first place increase key policy rates in this quarter itself. After all there were many allusions in the media of Israel and Australia hiking their rates. It can also be argued that monetary policies come with a lag and with WPI already nearing 6% and the base effect disappearing, there is certainly a case for urgency. Secondly, huge liquidity in the market leads to a potential for an asset price escalation. This compounded by large capital inflows could lead to bludgeoning asset prices. Infact in some ways, RBI has attempted to address this issue in the current review by hiking provision requirements for loans to commercial realty (which in my opinion can backfire since developers would pass on the increase in cost of funds to the buyers, and if demand refuses to be daunted there could be another rally of real estate price hike)

Finally some could argue that even if the RBI increased interest rates or upped the CRR; it need not have necessarily translated into higher costs for borrowers. This is because credit growth in India remains quintessentially weak, and banks would be hesitant to extinguish any demand for loans by increasing lending rates. And if their assets are not growing, banks would have no incentive to chase liabilities by providing higher deposit rates. So even tampering with policy rates would be akin to a token gesture.

However with the look of things, RBI is certainly not willing to let its growth objectives be hijacked by the whims of banks deciding whether to change their deposit and lending rates in response to RBI’s rate hike, or to demand and supply conditions in the market. Secondly a reversal in monetary policy would lead to increased yields on government bonds which in turn could thrust interest rates upwards and hence affect consumption and investment demand negatively.
But in my perspective the primary reason why the RBI refused to compromise on growth in this quarter, is because 60% of the Indian populace is employed in agriculture and the drought situation threatens to hit their disposable incomes badly. This drought promises not only to accentuate inflation, but also create a huge growth deficit. Which is why emulating Israel’s or Australia’s rate hikes may not be the best alternative for us. Finally an increase in interest rates could also lead to further capital inflows; which apart from inflating asset prices, would also be putting pressure on the rupee to appreciate.

The RBI seems to have got the trade-off right this time; but I doubt if tough choices are going to excuse themselves any time soon! It is indeed time for the tiger prowling on its emblem to prove its mettle. This quarter it has just growled; next time, get ready for its roar!