RBI should avoid a cut in cash reserve ratio

The Reserve Bank of India (RBI) faces the classical central bank dilemma, with both growth and inflation in uncomfortable territories. While no rate action is expected in the upcoming December announcement, the monetary policy stance and the near-term guidance, if any, would be of sheer interest.

Inflation has peaked — it would probably soften to less than 7.5 per cent by March, broadly in line with RBI’s projections. But it can stay fairly sticky thereafter — in an uncomfortably elevated range of 6.5-7.5 per cent for the major portion of 2012. The sharp deterioration in the growth trajectory would now increase the pressure on RBI to ease its policy stance. The central bank would possibly start facing the ‘behind the curve’ chatter again, this time on the easing front. Questions would now arise whether RBI over-tightened in the last few months. But an average headline inflation rate of around seven per cent is a clear deterrent against any rapid reversal in monetary policy stance — RBI would possibly hold the policy interest rate steady for the remaining months of 2011-12. Cuts in the repo rate could start from the April-June quarter.

Of late, there has been widespread speculation of a cut in the cash reserve ratio (CRR). I feel that would be a sub-optimal policy move at the moment. It could be perceived as prematurely diluting RBI’s inflation-fighting stance and stoke inflationary expectations, which have started coming down.

Rather, the continued use of open market operations (OMOs) to alleviate tightness in liquidity is a superior course of action. OMOs can be conducted at a measured pace, at the discretion of the central bank. OMOs would also help tame elevated bond yields — a CRR cut would not be able to achieve that in a sustained fashion. This is a particularly important consideration now, owing to strong possibilities of further overshooting of government borrowings in 2011-12.

Siddhartha Sanyal
Chief economist, Barclays Capital