By Shubhada Rao of Yes Bank
After being the most aggressive central bank among emerging economies in 2011, the Reserve Bank of India has finally let down its guard and relaxed monetary policy after a hiatus of three years. In its annual policy review for 2012-13, the RBI delivered a greater-than-expected 50 basis points cut in the benchmark repo rate.
Last month, the RBI had maintained status quo on interest rates, but stated that future rate cuts depended on the government embarking on a credible path of fiscal consolidation. In the 2012-13 national budget, the government stated its intent to curb the fiscal deficit to a more credible level of 5.1 per cent of GDP from 5.9 per cent in the previous fiscal year through revenue augmentation and efficient management of subsidy expenditure.
It was this announcement that provided the RBI with the required space to tweak its policy to address growth risks amid declining demand-side pressures. Monday’s start of monetary easing will help preserve the balance between growth and inflation, and bolster financial stability.
But the aggressive move appears preemptive as the ball is now in the government’s court to actually deliver on its fiscal consolidation and growth revival plan. Thus, by being proactive rather than reactive, the RBI’s monetary action is a clear departure from its past position.
Despite this proactiveness, the RBI has in no way diluted its hawkishness on inflation. Among continued upside risks to inflation, it cites high crude oil prices and pending adjustments to domestic-administered petroleum prices, and the recent depreciation in the rupee.
While the steady decline in core inflation shows demand-side pressures waning, most inflationary pressures actually seem to stem from the supply side. With weak demand, producers are unable to pass on the burden of higher input costs and interest rates fully onto consumers. But a large part of headline inflation is underpinned by supply bottlenecks, which monetary policy will have limited impact on.
So RBI’s dovish action on Tuesday is actually accompanied by a hawkish stance. While further monetary easing, albeit of a smaller magnitude, remains on the table, the timing would be contingent upon government’s timely adherence to a path of fiscal consolidation as outlined in last month’s budget. As such the RBI will wait and watch for the next few months.
The domestic macroeconomic conditions warrant an urgent response by the government to build on a bold move by the RBI. At this juncture the monetary easing needs to be complemented by prompt government steps to stimulate business confidence by focusing on mitigating supply bottlenecks through structural reforms.
Over to you, finance minister!
The author is chief economist at Yes Bank, India’s fourth-largest private sector bank.
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