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Monetary policy in uncertain times
Ila Patnaik, Wednesday October 11

The RBI’s inflation forecast seems rather puzzling, says Ila Patnaik.

When Mr Bimal Jalan took over as the Governor of the RBI, few people expected the Old lady of Ballard Pier to set the nearby ocean on fire. But there are less dramatic ways galvanising the sluggish into action and Mr Jalan has chosen the path less travelled by.

That is perhaps why the Mid-Term Review of Monetary and Credit Policy for the year 2000-2001 announced by him yesterday will remembered more for what it does for banking reform than for the monetary and credit policy it spells out.

However, because the immediate cannot be sacrificed at the altar of the long term, it is useful to see what it does have to say about monetary and credit policy over the next six months.

And the answer is: not a great deal. True, that it is as clear a statement of policy as one might expect in a fundamentally uncertain situation.

That is the justification, and the right one, for the stance that things cannot be -- indeed will not be—decided only twice a year and kept unchanged during the rest of the year.

The RBI has to respond to domestic and external conditions in a much more lively and alert manner now than it used to in the past.

This basically means that banks and financial institutions would do well “to make sufficient allowance for unforeseen contingencies, including possible changes in monetary conditions. So the RBI has warned that its policy could change in response to the emerging situation and that monetary instruments will be used flexibly. Consequently, the policy is the “non-event” that the market expected it to be.

What it does contain, therefore, is, one, a number of measures intended to strengthen the financial system and improve the working of financing markets and two, the RBI’s outlook of the economy for the current year. The latter is of interest because it sets the scene for the likely monetary and credit policies.

While on the growth scenario the RBI has taken the expected position of lowering its expectation of the GDP growth rate by 0.5 percent to 6-6.5 percent, its stance on the inflation front is rather puzzling.

According to the statement the rate of inflation for the year as a whole is likely to be close to the average of the last two years.

Notably no numbers are specified. Last year the average annual inflation rate based on the WPI-ALL was 3.3 percent and in 1998-99 it was 5.95 percent. Thus the average rate expected for the current year is 4.6 percent.

During the first half of the year the average inflation rate has already crossed 6 percent. Unless the average inflation rate for the second part of the year falls to 3 percent the rate would be higher.

After the oil price hike the inflation rate is going to be higher and not lower than in the first half. The RBI’s forecast thus seems to be rather puzzling.

Further, on the liquidity front in 1999-2000 money supply (M3) growth was lower than targeted at 13.6 per cent. The RBI expects it to be on target this year. However, reserve money growth is forecast to be “significantly lower than last year”.

There is an interesting question here. If reserve money growth is expected to be lower but money supply growth to be higher then either the RBI expects the reserve money target to be crossed or the money multiplier will be raised by lowering the cash reserve ratio.

While the former may happen due to increases in net RBI credit to the government—and also by the additions to the forex reserves of the RBI from the Millennium India Bond scheme—the announcement has not taken into account—nor are there are plans to lower-- the CRR. If anything indications are that money supply will be tightened.

Indications of a tighter money policy and a hardening of interest rates are present in the concerns expressed by the RBI. The first is of course the fear of inflation. One of the main reasons for not easing monetary policy would be the higher expected inflation in the economy due to the rise in oil prices.

Despite its low inflation forecast the RBI has expressed concern that the “domestic inflationary outlook is somewhat uncertain”. Even though inflation in this instance may be cost-push and there is no conclusive evidence that it is a monetary phenomenon in India—that higher money supply lead to higher prices—the RBI’s monetarist stand and its fear of inflation has been evident in the past.

Further, the increase in international rates reduced the interest rate differential and caused pressure on the rupee. Currently international rates are not seen to be moving downwards. The European Central Bank raised its key interest rate by a quarter point to 4.75%.

The Economist reports that America’s Federal Reserve has left interest rates unchanged but signalled that the next move was more likely to be up than down. An outflow of rupees on account of lower interest rate differentials (both nominal and real as Indian inflation is higher than international inflation rates) at a time when the current account is rising, will put further pressure on the rupee.

Another reason to keep interest rates high would be that to keep real returns on deposits the same, nominal rates need to be higher as the inflation rate has risen. When in April interest rates were brought down, inflation had fallen to historically low levels and thus there was no fear of a reduction in real rates that would discourage savings.

A reason to lower rates could be that it would be good for the manufacturing sector that is faced with prospects of the slowdown continuing and which might be helped by lower rates.

Though industry is always clamouring for lower interest rates, this time even the finance minister is concerned. However, the concern for growth is usually a matter of lower priority for the RBI that worried more about the inflation rate.

So the real question is where do we go from here? The answer is going to depend, not so much on what the RBI does with interest rates over the next six months but on what the government does to step up its own programme of investment.

In many ways, the real problem with industrial growth lies in the poor investment scenario and the RBI alone cannot be expected to rise to the occasion.

As usual, in a week from now the credit policy will be forgotten and the attention would have shifted back to the finance ministry. That is why it is useful to bear in mind that at the end of the day, the RBI is just another cog, albeit a large one, in the machine.

If the machine has broken down, even a perfectly functioning cog isn’t going to help much.

The author is the editor of NCAER’s Macrotrack.

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