No pain, no gain

RBI uses its only weapon, the government can do more

There were several reasons why few expected the Reserve Bank of India (RBI) to take youthful strides rather than baby steps this week. Few expected an increase of 50 basis points (bps) in the policy repo rate. Ignoring the purely ideological, rate-hike sceptics fall into two categories — those who believe that protecting growth and corporate bottomlines is more important than curbing inflation and those who believe that monetary policy may have reached its limits and only action on the supply side can break inflationary expectations. To be sure, RBI itself has admitted that there are limits to what it can do and that the government must do more. As RBI Governor Duvvuri Subbarao put it ever so politely, “The Reserve Bank’s efforts of achieving low and stable inflation could also be supported by concerted policy actions and resource allocations to address domestic supply bottlenecks, particularly in respect of food and infrastructure.” When saying “could”, he probably meant “should”!

The central bank can do precious little about “cost-push” inflation, given the externally set crude oil prices and politically determined administered prices of food. Since RBI cannot control cost-push inflation and supply-side rigidities, it uses the only weapon in its armoury, namely rate hikes, to combat demand-pull inflation, weaken pricing power of producers and alter inflationary expectations. Having declared inflation its number one enemy, the central bank had no option but to increase rates. And since most expected a 25-bp hike, including this newspaper, RBI chose to defy expectations and double the ammo for the second time this year.

It would seem the central bank is convinced that its determined actions over the past year are bearing fruit and in at least two sectors – real estate and automobiles – demand- pull pressures have been considerably deflated. This pain, RBI seems convinced, is the price that must be paid to achieve better-quality growth. All this is well taken. The only caveat we would add is that while many expect a further 25-bp hike six weeks from now, the time has come for the central bank and the government to put their heads together and ask the question whether monetary policy alone can wage and win the battle against inflation and whether the acts of omission and commission of the political establishment are weakening the government’s ability to curb inflationary expectations. Be it global factors like the policy actions of the United States, European Union and China or exogenous factors like the monsoon or political economy factors like the government’s ability to break inflationary expectations, each plays its own role and needs to be handled by macroeconomic authorities. It would seem the government’s strategy is now based on the assumption that it is unlikely to ease the supply constraints in the short term, nor are external and exogenous conditions likely to turn much favourable in the near future, so use as much of the monetary policy firepower as possible to bring down prices, even if it hurts growth in the short run.