Wise caution

RBI shifts stance, mindful of uncertainty

The Reserve Bank of India’s sixth bi-monthly monetary policy for 2016-17 will have surprised most onlookers. Strong hopes had been expressed — hopes hardening, in fact, to near confidence — that RBI would cut the policy rate by at least 25 basis points (a quarter of a percentage point). However, the central bank, in fact, did no such thing. Not only did it hold the policy repo rate constant at 6.25 per cent, it also indicated that the monetary policy stance was now neutral, rather than accommodative. The decision was taken with the support of all six members of the Monetary Policy Committee.

 
The caution is to be commended. While the economy’s macroeconomic indicators are not flashing red, and the Union Budget appeared to have kept the fiscal deficit under control, there are significant questions about the future that should nevertheless be asked. RBI was right to point to significant uncertainties in the future path of inflation and growth, such as the possibility of an increase in crude oil prices and the effects of the Seventh Pay Commission award. RBI is now, following an agreement with the Centre, focused strictly on targeting consumer price inflation; and, as it correctly pointed out, non-fuel and non-food inflation continues to be sticky in spite of a decline in the overall rate of inflation. This suggests that inflation expectations continue to be higher than RBI can be comfortable with. Any cost-push shock to prices could, therefore, have a cascading effect, causing the central bank to miss its stated inflation target of four per cent. Given this context, it might have been far too optimistic to expect RBI to cut rates.

 
Most of the expectations of a rate cut were centred around the fact that private investment continues to be depressed, and that lending to industry has sharply slowed. RBI recognises this problem with financing in its statement. However, it argues later that it is not rates that are necessarily the constraint. It points out that “timely transmission” of the policy rates to banks’ lending rates needs the banks’ non-performing assets issue to be more swiftly addressed, and banks to be given greater security in terms of recapitalisation. It is difficult to read this as anything other than a suggestion that RBI feels it cannot use monetary policy to revive growth, even in the shadow of the demand destruction caused by demonetisation, when the transmission mechanism is so faulty. To revive investment, the government must address the banks’ problems with greater urgency.

 
RBI was in general optimistic about the economy’s bounce-back from the shock of demonetisation. While it did not sugar-coat the impact of the measure on some sectors, it nevertheless forecasts growth in gross value added at 6.9 per cent this financial year and a “sharp recovery” to 7.4 per cent in 2017-18. Taken together with the news that withdrawal limits are planned to be relaxed to Rs 50,000 a week from February 20 and completely removed after March 13 , this suggests that the transient effects of demonetisation are passing relatively quickly, which is good news. However, the underlying problems of the economy remain, and it is up to New Delhi to deal with them post-haste.