Monetary Policy: “The worth of that is that which it contains”

A hike in repo rate – the rate at which banks can borrow from the Reserve Bank of India – by yet another 20 bps taking it to 7.75%, a 50 bps hike in Cash Reserve Ratio – a cash deposit that banks have to maintain with the RBI at the prescribed percentage of their net demand and time-liabilities – taking it to 6.5%  so as to suck out about Rs14,000 cr from the market, and a reduction in interest rate that the RBI pays to banks on deposits maintained with it under CRR are what constitutes the monetary prescription of the RBI. It is obivously meant for: one, constraining the growth of liquidity in the system; two, make credit dearer; and three, deflate credit-multiplier effect – all in the anxiety of arresting the rise in inflation that has already touched 6% plus.

The high growth rates coupled with rising inflation have of late become a global phenomenon, and hence many central banks have either sprung into action or on the verge of taking corrective policy decisions. The European Central Bank and The Bank of Japan have each raised their interest rates by 25 bps, while the People’s Bank of China has raised its one year rates by 27 bps, along with a rise of 50 bps in reserve requirements. Driven by these global developments and its belief that in the long run, high inflation is inconsistent with high growth, the RBI has tightened its monetary policy to arrest the spiraling growth in money supply. This has, of course, raised many eyebrows: some critics have dubbed the tightening of the monetary policy measures by the RBI as a  ‘growth killer’, for, in their opinion, current inflation being more due to ‘supply-side’ constraints rather than demand-driven, monetary measures are of little or no avail. Let us take a critical look at it.

First, inflation. It hurts common man. To be precise, it hurts badly those who do not have a steady source of income. It even hurts savers by adversely impacting their returns on investments. It hurts exporters by weakening their price competitiveness – particularly in the current scenario of buoyant foreign exchange inflows. And, once inflationary expectations rise and inflation gets entrenched, it becomes very difficult to wriggle out of it. Hence, high inflation is not acceptable politically. That aside, supply-side corrections do take time to respond to corrective measures. And in the meanwhile, if credit-financed spending – the buying binge that we are today witnessing in the field of consumer durables and real estate – is allowed to rule the roost unchecked, it would only feed the inflation further, making the lives of those at the bottom of the pyramid more worse. No central bank worth its name can keep its eyes closed when that is what indeed is happening.

Coming to the growth side discussion, we must bear in mind what textbook economics prescribe: macroeconomic stability – low inflation, stable interest rates, comfortable balance of payments that squarely rests on appropriate fiscal balances – is the sine qua non of sustainable growth. In this context, the arguments of pro-growth advocates need to be analyzed from the perspective of our none-too-happy fiscal position. The combined fiscal deficit of the center and states that touched a high of 9.3% during 1990-91, no doubt, dropped to 6.3% by 1996-97, but again climbed to 9% plus by 2002-03. Encouragingly, it has shown a downward trend since then, touching 6.5% by 2006-07. Yet all is not that well with our fiscal gains, for we have fiscal deficits along with revenue deficits, which means much of government borrowings are used for revenue consumption rather than for capital investment that can at least generate returns at a future date. The current share of fiscal profligacy that stood at 41.5% in 2005-06 is definitely a matter of concern, particularly when inflation is on an upward spiral, for it would only fuel further rise in inflation by simply increasing money supply in the system. There is yet another danger with continuing fiscal deficits: it affords the pleasure of spending to the current generation and passes on the burden of debt servicing to the later generation. Despite these theoretical prescriptions, we are continuing with fiscal deficits of considerable size, and hence  the central bank cannot sit quiet when inflation is fast raising its head, even if it meant moderating growth for a while. 

John F Nash, the Nobel laureate and the father of game theory, when asked for his views on the trade-off between growth, and inflation by ET in Delhi, said: “This question is statistical one. We can have an economy that would be called as growing, but there could be no real growth at all if it precisely involves a growth in just the money supply.” Continuing his interview, he made his preferences clear: “Growth without inflation would be the ideal thing to have”.

Looked from this perspective, it becomes obvious that what the RBI did is quite rational. Indeed the task of the RBI will be more daunting in the days to come, for the increased capital inflows, which may further grow owing to the recent rise in domestic interest rates, will only increase money supply, unless rupee is allowed to appreciate. Even that idea cannot be entertained for long, since it adversely impacts exports. The trade deficit being as high as 7% of GDP, it is essential to restrain growth in money supply and credit.  Therefore, the RBI has to do a balancing act of maintaining inflation at the acceptable level of, say, around 5% while sustaining growth momentum, with all moderation.

 

(May, 2007)