RBI's hard choice

Govt?s inaction should force the bank to delay deep rate cuts

The Reserve Bank of India bears a responsibility to control inflation and promote growth, one it shares with the government in New Delhi. The Centre has continually shirked its responsibility. The Budget presented for 2012-13, while claiming to focus on fiscal responsibility, leaves much undone. Its projections for growth, revenues and deficits depend on the government taking tough decisions — “biting the bullet”, the prime minister had called it. However, the first bullet to bite was in allowing (nominally deregulated) fuel prices to rise. There is no sign of any such move right now. Given that, the government’s commitment to controlling the deficit, and thus inflation, appears extremely doubtful. The Reserve Bank of India (RBI) has pushed interest rates very high in an attempt to control inflation. In December, it signalled a change of stance — but it has not yet cut rates, although it could have. The RBI, although it too is responsible for growth, can now ask: how is it possible to cut rates in an environment in which the fiscal authority’s claims of consolidation have lost all credibility? The government, through continued inaction, has allowed the RBI to use a very powerful argument against rate cuts in the credit policy review on April 17.

The RBI’s decision will not be easy. On the one hand, there are significant risks to growth. Manufacturing showed a recovery in February – according to the volatile Index of Industrial Production, at least – but that is likely to be temporary, as it came on the back of an enormous jump in the production of consumer durables which is unlikely to be sustained. Meanwhile, risks have built up on the external account. The balance of trade has turned against India, with gold and petroleum imports spiking. The current account deficit, which was at a record high in the last quarter, is being financed mainly by short-term flows from foreign institutional investors, which is a recipe for disaster. The only real cure for this is increasing foreign direct investment – on which count the government has failed to deliver – or in a strong recovery in terms of growth, which would reduce the possibility that capital flows would suddenly reverse.

On the other hand, there are very real concerns that inflation, driven up by supply-side factors, has now become generalised. Core inflation is now high, reflecting either the previous price rises passing through the economy or a worrying increase in expected inflation. Unfortunately, India has few ways of measuring expectations of inflation more precisely. The RBI, if it is to maintain its reputation as an inflation hawk, could find itself unable to ignore the possibility that expectations have become unanchored. The bond markets appear to have factored in a decrease of 25 basis points in rates in the credit policy. This might be too hopeful, given that the RBI has consistently said that action from the government is needed to give it the space to cut rates. The government’s abdication of fiscal responsibility cannot have any other outcome but to force the RBI to zero in on controlling inflation.