Monetary policy: Is the Central Bank more ‘hawkish’ than warranted?

In its latest Mid-Quarter Monetary Policy Review (September 2012), the RBI has slashed CRR of the net demand and time liabilities (NDTL) by 25 basis points from 4.75 % to 4.50 % . But it left untouched repo rate (at 8.0%), reverse repo rate (7%), and the marginal standing facility (MSF) rate and the Bank Rate at 9.0 %. The industry, amidst a severe slowdown was expecting rate cuts. But they were bit disappointed. The RBI in its press release said that this reduction of CRR would infuse Rs 17,000 crore into banking system. While it lauded government’s commitment to reduce fiscal deficit, it said, however, that that elevated inflation rate and core inflation are beyond comfortable level, preventing any rate cuts.

Is the RBI more ‘hawkish’ than expected to be? It seems to be. Remember that ‘policy rate’ has been on elevated level since March, 2010. Despite this, the inflation has not been tamed to RBI’s comfort level that is 5-6%. The economy is still in ‘doldrums’. And the industrial sector is on a free-fall! Given the fact that the government has shown serious commitment to reduce fiscal deficit and the inflation remains sticky despite a tight monetary policy, it would have been probably better to infuse much needed capital to the bleeding industrial sector. The RBI has always maintained its pro-poor stand. While being ‘hawkish’ is good, going too far in the pursuit of “successful chaser” would do more damage than good to the country. It seems that the RBI is chasing a distant dream.

The RBI Deputy Governer Subir Gokarn has admitted that its elevated policy rates contribute to one-third of the slowdown of the Indian economy. What happens to unemployment rate? Firms being liquidity constraint both in the domestic and foreign market, is expecting the RBI to deliver. This curtails their investment plans.

High interest rates may be counter-productive to the very objectives RBI is pursuing for. First, growth of loans to the agricultural sector will decline considerably. Further, if it succeeds reducing credit supply to industry in the face of agricultural stagnation, it may push India into a stagflationary situation. Second, the rise in the interest rate leads to increased cost of production in the industries. Industry, following a mark-up rule, shall pass rise in cost to consumers and this will only accelerate the inflation. Finally, we may land in a high inflation rate if the RBI in pursuit of curbing inflation maintains status quo of key policy rates in the face a bad cropping session.

Given the free-fall of the industrial sector and the impact of rise in diesel price, still it could have been better if the reserve bank could have cut its key policy rates. Although employment generation in the organized industrial sector is very less, yet the economic slowdown warrants a rate cut. Pushing too far will not ultimately serve anybody’s interest.