The Reserve Bank of India, in its mid-quarter policy review, has unambiguously signalled a shifting of stance. Not only does the RBI reiterate in its statement that “further rake hikes may not be warranted”, but it concludes by saying that “from this point on, monetary policy actions are likely to reverse the cycle, responding to the risks to growth”. This is a welcome recognition from India's monetary authority of grim reality. There is little doubt that a tight money policy — which continued even as domestic policy making froze and the external environment turned the most uncertain it had been since the financial crisis of 2008 — has caused the India growth story to come to a screeching halt. The RBI was forced to acknowledge industrial production, particularly in capital goods, appears to be stumbling badly, reflecting the constraints on investment of a high interest regime. As the RBI says: the causes of the decline in growth can be traced to an “uncertain global environment, the cumulative impact of past monetary policy tightening and domestic policy uncertainties”.
Admittedly, the RBI cannot be held responsible for either the concern radiating out across the financial markets from the euro zone, or for New Delhi's inability to push through growth-enhancing reform. Yet it has been clear for some time that growth and inflation are both slowing. A strongly-held belief that inflation expectations are not adjusting quickly enough has perhaps caused the central bank's reactions to be slower than most observers would like. Hopefully this approach will not continue in the crucial months and weeks to come. Inaction has also been on display in the foreign exchange market, in which speculators have been allowed to take one-way bets on the rupee — while the RBI seemed to think that, even though it was a regulator, its hands were tied. Some actions have now been taken to discourage speculation in the foreign exchange market. It remains to be seen if they will be enough.
The primary focus of the RBI, however, should remain slowing growth and inflation. Food inflation is at its lowest point in four years; fuel prices are being slowly moved up and down by oil marketing companies; the growth slowdown itself is being reflected in pricing. While inflation may still be above the RBI's comfort zone, it is difficult to believe that rational observers still have inflationary expectations that are high enough to be problematic if a rate cut were to be announced. In the end, a central bank's job is essentially to manage expectations: if it does merely what is expected of it, it may not be seen to be in control. The RBI perhaps raised rates too slowly, and in stages that were too small to properly impact market participants. As it moves towards cutting rates, questions should be asked in Mint Road as to how to avoid that trap this time. The answer, perhaps, is to ensure that a reasonably-sized cut in rates is taken soon enough, which will be able to work its way through the system — and perhaps rescue some part of 2012-13 GDP growth.