The choices facing the Reserve Bank of India (RBI) on monetary tightening are two. One, keep raising interest rates gradually keeping in mind the risks to a recovery posed by a sluggish world economy, rising commodity prices if demand picks up globally, an uncertain monsoon, and a rising dollar tide to resurgent emerging economies. Two, frontload interest rate hikes to avoid painful raises later. In the event, the central bank has chosen the first option by raising short-term policy rates and cash reserves of banks by a quarter of a percentage point. Weighing in for this was also the need to keep interest rates low till the bulk of the government’s gigantic borrowing programme is behind it. The gradualism, of course, risks elongating the policy transmission lag. The Rs 12,500 crore the central bank plans to suck out of the financial system by raising the cash reserve ratio is not likely to exert undue pressure on liquidity when banks are parking, on average, Rs 78,600 crore every day with the RBI. And with the system awash in money, banks are willing to absorb the hikes in policy rates as well.
This scenario plays out well if, as seems to be the case, inflation has peaked. The 9.9 per cent wholesale inflation in
March was slightly less than market expectations ahead of a non-adverse base effect setting in from April. Yet the March number is significantly higher than the central bank’s baseline projection of 8.5 per cent. Food price inflation is still uncomfortably high but is showing signs of slowing. Another worry is that core inflation — minus volatile food and energy prices — has climbed to 4.7 per cent in March from 4.2 per cent in February, suggesting underlying pressures. The central bank, while aiming for a March 2011 inflation rate of 5.5 per cent, sees significant upside risks in food prices staying firm because of structural shortages, rising global commodity prices, mounting demand pressures at home and household inflationary expectations remaining heightened.
The RBI’s focus is now singularly on managing inflation. India’s economic recovery, in its view, is consolidating and the growth projection for 2010-11 is 8 per cent with an upward bias. Apart from inflation, the other issue confronting the RBI has more to do with its role as the government’s debt manager than as the architect of monetary policy. Although lower than last year, government borrowing in 2010-11 will require a third more of new gilts to be issued. This runs contrary to the central bank’s policy stance of draining excess liquidity.