Subbarao defends monetary policy pause

Talks tough on inflation, says growth story credible, not inevitable 1991-type implosion not imminent

Reserve Bank of India (RBI) Governor D Subbarao on Tuesday came out with a strong defence of the monetary policy stance announced yesterday. Acknowledging that his decision of not to cut interest rates amid slowing economic growth had not gone down well with the business community, Subbarao gave detailed reasons for his decision.

Why no rate cut
The governor says, though wholesale price-based inflation and core inflation have moderated, both are still above acceptable levels. More worrying for the central bank is that retail or consumer price-based inflation is not only high (10.4 per cent in May) but still on an uptrend. “Moderation in WPI has not been transmitted to CPI,” he said while addressing the business community in an event. Subbarao reiterated there was no new normal for inflation; the medium-term goal was still between four and five per cent.

Tight policy & growth
The point, he said, was that control on inflation was needed for sustainable growth. Though, he said, some sacrifice in growth was an unavoidable price to tame inflation, if prices stayed higher for even the medium term, it was inimical to growth. “Low inflation is an essential precondition for securing medium-term growth. High inflation makes investment decisions uncertain,” Subbarao said.

Also, he argued, inflation being a regressive tax, it hurts the poor the most. “Their voice (poor), silent as it is, must also be heard,” the governor said.

Growth constrictions
The former IITian offered a statistic to counter this argument, the main concern of India Inc. “What proportion is interest cost in the total cost? Just about three per cent,” he put simply. He elaborated that real interest rates were lower than in the pre-crisis period, so there were other factors at play for investment remaining sluggish.

Growth, he said, needed to be supported by higher investment but the high fiscal deficit was crowding out private investment — in other words, putting the ball squarely in the government’s court.

“The most important thing we need to do to revive growth is to revive investment and not support consumption so much now. To contain the fiscal deficit, government must reduce unproductive expenditure and not raise taxes alone,” he said.

What drives inflation?
That monetary policy was not the right tool, as inflation was being driven by supply-side issues has been another argument of his critics. This also found support from Finance Minister Pranab Mukherjee, who advocated ‘adjustment’ by RBI just two days before the policy review was announced. “We need to tackle food inflation by removing the supply-side constraints. It need not be tackled by monetary measures, as the ability of monetary policy to tackle food inflation is limited, ” Mukherjee had said last Saturday.

Subbarao, however, countered that high inflation — if it persists for a long time, no matter what the drivers are — could unhinge inflation expectations, as it eventually gets generalised. He also said that apart from supply-side issues, demand pressures were also there. In particular, rural consumption had gone up as a result of increase in real wages..

1991 and now
The situation now is different from 1991, he explained, as the structure of the economy had undergone significant changes over these two-odd decades. The services sector’s contribution has increased significantly. In addition, financial markets are more mature now, capable of absorbing shocks. And, foreign exchange reserves are much larger, able to cover eight months of import cover as against just two months in 1991.

Growth story still credible
Though the potential growth rate of the economy may have declined to a yearly eight per cent now as compared to 8.5 per cent before the global financial crisis of 2008, the India growth story is still a credible one, stressed the governor, as the drivers of growth, like entrepreneurism and the demographic dividend, are intact.

However, he concluded his speech on a note of caution. “But, the India growth story is not inevitable!”