Choices facing the RBI: Between a rock and a hard place

By Akrita Reyar | Updated: Jan 31, 2014, 19:36 PM IST

Akrita Reyar

The economy is sluggish, inflation is unacceptably high and the common man has a long list of woes. In the midst of this ‘not so rosy’ picture, it falls on the shoulders of Raghuram Rajan to make the Reserve Bank of India look like it’s in control of the situation.

And confidence is exactly what Rajan wanted to display when he spelt out the bank’s third quarter review of monetary policy on January 28 this year.

While markets were abuzz that the RBI would keep rates unchanged, the RBI Governor thought otherwise, and raised repo rate by 25 basis points from 7.75 per cent to 8.0 per cent.

Repo is the rate at which the RBI lends money to commercial banks, and which in turn influences the rates at which banks offer loans to all of us. This, of course, is critical to decide the cash flow or liquidity in the market – for fuelling demand by consumers or borrowings by corporate for investments.

Why after all were there speculations that rates would remain in status quo mode? The main reason that analysts were at pains to point was that the economy was slowing and demand contracting. The fear of slowdown is graver in the third quarter, a fact admitted by the Governor himself.

Raghuram Rajan pointed out that “industrial activity remains in contractionary mode, mainly on account of manufacturing, which declined for the second month in succession during Q3”. He also knows that “consumption demand continues to weaken and lacklustre capital goods production points to stalled investment demand”.

Neither is the prediction of 5% growth this year nor 5.5% GDP expansion next year a very optimistic outlook, considering the near double digit growth aspirations of our Prime Minister not so far back in time.

Rajan has further admitted that the fiscal tightening would only “exacerbate the weakness in aggregate demand”.

Why then has he chosen to bite the bullet?

The answer for this lies somewhere in Rajan’s December 18 guidance during mid-review. He had clearly spelt out that inflation, particularly Consumer Price Index, would remain his main concern, subject to economic data that came in.

Economic data only confirmed that CPI is unacceptably high at close to 10%, and despite fall in food and vegetable costs, retail inflation is pushed upwards because of second round effects in the service sector, especially wage pressures.

Raghuram Rajan has termed inflation as a destructive disease which is like a tax that is grossly inequitable, falling hardest on the very poor. He has also blamed it as one of the prime causes for the weak rupee.

It was thus critical to address inflationary risks resolutely, by aiming to bring down CPI down to 8% next year, and further brought down to 6% by January 2016.

His rate hike to 8% was, therefore, not only consistent with guidance issued in December, but also meant to set the economy on the “glide path” for disinflation as indicated by Dr. Urjit Patel Committee.

The RBI governor has said that "we are neither hawks, nor doves. We are owls. The owl is traditionally a symbol of wisdom. We are vigilant when others are resting."

Caution and wisdom may have been evident to some extent in this review, but what it also shows is something of Raghuram Rajan’s thinking. For him, tackling inflation has taken precedence over growth. And he has also shifted focus completely to CPI from Wholesale Price Index.

The RBI governor has announced that he would be accepting the Dr. Urjit Patel Committee recommendations and monetary policy reviews would be undertaken every two months from now on.

Considering that the next review would take place on April 1, 2014, one can clearly say there will be no surprise next time or even in June. Rates are set to stay where they are for some time to come.