RBI cuts rates. Now Delhi must act on subsidies and reform
The Reserve Bank of India has done more than it was expected to, and now the central government has no excuses left. The Monetary Policy Statement for 2012-13 that was released by RBI Governor D Subbarao on Tuesday announced a cut in the repo rate by 50 basis points (bps) to eight per cent. The reduction was larger than the markets expected; the consensus was that, if a cut would happen at all, it would be of 25 bps. In taking this action, the RBI has acknowledged that the monetary policy transmission mechanism in India is weak, and that smaller steps are unlikely to be as effective. However, it is instructive to read the entire statement. The RBI continues to be concerned that the economy conceals substantial inflationary pressures — the upside risk to inflation, it says, is considerable. Given that, it may be overoptimistic to expect this is only the beginning of a sequence of cuts.
Indeed, the RBI makes its concerns explicit. The government’s numbers for its fiscal deficit – crucial to contain inflationary pressure and to avoid crowding out of productive private investment – are dependent on its capping subsidies, it says. The statement reiterates the conventional wisdom that fuel prices are not likely to decrease in the medium- to long-term. Given that, a change in the administered prices of petroleum products (including those of nominally decontrolled petrol) is overdue. The words in the statement are unusually forthright: “Persistent demand pressures emerging from inadequate steps to contain subsidies as indicated in the recent Union Budget will further reduce whatever space there is [for monetary policy]... Overall, from the perspective of vulnerabilities emerging from the fiscal and current account deficits, it is imperative for macroeconomic stability that administered prices of petroleum products are increased to reflect their true costs of production.” The statement adds that concerns of a complete pass-through of an increase in fuel prices causing inflation to spiral out of control may be overdone. It quotes survey data suggesting that companies do not have great pricing power currently. Little should stop the government from “biting the bullet”.
The RBI, therefore, heartened by a moderation in inflation that it acknowledges may be temporary, has used whatever little space is available to take a step that it hopes will boost growth. The statement correctly points out that growth is below the trend rate, and that there is scope for monetary policy intervention. But that is not, it insists, the central cause: “It must be emphasised that the main reason for the apparent decline in the trend rate of growth relative to the pre-crisis period is the emergence of significant supply bottlenecks on a variety of fronts — infrastructure, energy, minerals and labour. A strategy to increase the economy’s potential by focussing on these constraints is an imperative.” The government has continually blamed both the policy slowdown and high interest rates for the economic malaise in which India finds itself. The problem of high rates has been solved as much as the RBI thinks is possible in the current environment. The statement has laid out what needs to be done now: reform of administered prices and subsidies to bring down the fiscal deficit; and growth-boosting supply-side reform.
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