The Hindu Business Line : Reactive monetary policy

Time was when monetary policy was fairly easy to administer. All through the five years of 8 per cent growth, money supply and headline inflation provided the Reserve Bank of India (RBI) with the necessary lights to an understanding of what the ideal interest rate at a particular moment in time ought to be. So long as the economy was rolling forward on its own, any faulty reading of these numbers did not matter much. By late 2006 the RBI had begun tightening monetary poli cy in a bid to control what it thought to be an ‘overheated’ situation; but the economy bashed on regardless, crossing that hurdle without a hiccup to peak at 9 per cent in 2008-09. That may not be possible anymore; equally the RBI may find itself tripping over those precious benchmarks.

Consider the money supply scenario. For decades the RBI maintained the annual money supply growth rate at a benchmark level of 15-17 per cent. Yet the annual GDP growth climbed steadily from 5 per cent in the 1990s to 8 per cent in the last five years. Domestic money supply did not matter to the leading private sector units since global capital was in plentiful supply; the central bank’s calibration also worked because Government borrowings were scaled down under the Fiscal Responsibility and Budget Management Act. All that has changed now; the RBI has to inject liquidity for two large constituents: the Government’s borrowing programme and the private sector that has nowhere else to turn to in the medium term. Just where this places the money supply target now that some form of deficit monetising is inevitable is open to question. The RBI’s emphasis on the Wholesale Price Index is even more problematic. So long as the WPI converged with the CPI the RBI could continue to hold the former as a weathervane for monetary policy adjustments — contrary to the use of the latter in other countries. Now the WPI has plummeted to below zero while the CPI for urban non-manual employees under the new, linked All India index, has averaged 9-10 per cent since January. Monetary policy has now to confront the self-inflicted paradox of allowing high real interest rates during a slowdown.

As never before, the next medium term monetary policy of the RBI will be reactive. A major part of the agenda has been set partly by the Government; so it will have to pump-prime the economy. The other has been set by its faithful adherence to the WPI as inflation-indicator and its logic now demands a drop in real interest rates.

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