Limited headroom

Entirely in line with expectations, the Reserve Bank of India in its mid-quarter policy review announced on Tuesday reduced the policy repo rate by 0.25 percentage points to 7.5 per cent. On strict monetary grounds the case for a rate cut might not have been so obvious. However, in its first policy statement after the budget, the RBI would have found it difficult to resist pressures and not so subtle hints including from the Finance Minister himself. The budget had stressed fiscal consolidation, which the RBI has been asking for, as an essential complement to the anti-inflation stance of its monetary policy. So irrespective of whether the revised fiscal road map — which among other signposts calls for the ratio of gross fiscal deficit to GDP to decline to 4.8 per cent in 2013-14 — can in fact be reached, the RBI was forced to act. However, even without the government’s prompts, the RBI has not ignored growth concerns. Recent policy statements have, in fact, shifted the RBI’s focus away from inflation towards growth. As so often in the past, the mid-quarter review explains why monetary policy has to balance the conflicting claims of growth and inflation.

Growth has decelerated significantly. In the third quarter of the current year, GDP growth at 4.5 per cent was the weakest in 15 quarters. Particularly worrying has been the decade-low growth in the services sector. Industrial output has turned positive in January but significant weaknesses in capital goods production and mining activity remain. Initial estimates of the kharif crop indicate a lower level of foodgrains production compared to last year. If these suggest an easier monetary policy, the messages from the inflation front are not so clear-cut. While WPI inflation has edged up to 6.8 per cent in February from 6.6 in January, the other widely relied upon inflation index relating to core inflation — non-food manufactured inflation — has been coming down. Food inflation has remained worryingly high. Persistently high food prices have a negative impact on inflation expectations. They also explain the growing wedge between wholesale and retail inflation. Inflation is expected to remain at around the current levels during 2013-14. A competitive interest rate is necessary for reviving investment, but it needs to be backed by other measures such as easing supply constraints, staying the course on fiscal consolidation and emphasising quality governance. For these reasons, while the monetary policy stance underscores the need to address growth risks, the headroom for further monetary easing remains quite limited.

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