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How RBI lost the plot on tackling inflation

Given a choice, in a poor country like India it is always better to risk inflation and opt for growth than risk deflation, which will destroy jobs and growth

opinion Updated: Aug 09, 2017 08:19 IST
Urjit Patel got a lot of criticism for the thing he was not responsible for: Demonetisation. It was a political decision, an executive decision
Urjit Patel got a lot of criticism for the thing he was not responsible for: Demonetisation. It was a political decision, an executive decision(Mint)

Ever since it got hauled over the coals for allegedly mishandling the post-demonetisation scenario, the Reserve Bank of India (RBI) seems to have lost some of the halo it was previously endowed with. The current governor, Urjit Patel, with his tongue-tied approach to communicating with the media and public, stands in contrast to his predecessor, whose loquaciousness stretched far beyond monetary policy.

In his defence, one can certainly say that Patel has faced headwinds that were different from those faced by his predecessors. The latter faced one huge disruption or challenge during their tenures, mostly driven by external turbulence or internal fiscal profligacy (sometimes both), but in Patel’s case it is none of the above. His 10-month tenure has seen turbulence from unexpected directions almost every alternate month. These disruptions were not externally induced, nor did they have any easy textbook solutions. This is why the RBI under Patel seems to have lost the plot, especially in its core function of monetary policy.

When you have one disruptive variable to deal with, you can try the usual remedies and hope for the best. When you have a series of disruptions, each cascading into the other, your best may not be good enough. The learning time is too short to figure out pat solutions.

Let me just list some of the disruptions the Patel-led RBI has faced. The first one was the simplest — an institutional change in how interest rates are set, with the governor’s prerogative on rates being replaced by a panel of six called the Monetary Policy Committee (MPC). While this in itself can’t be called a major disruption, what it did was disorient the RBI from its composite role which involves not only deciding the price of money, but also managing growth, maintaining the credibility of the financial system, supervising banks, and managing day-to-day volatility in the money and exchange markets.

Last October, the financial world thought the MPC was the big change, when other, bigger, disruptions were about to crash an already slowing economy. The MPC became almost irrelevant in the process. Whether it was the deluge of deposits coming into banks after demonetisation or the large interest rate subventions and farm loan waivers announced after December 31, the MPC was reduced to a bystander in influencing the price of money. From this month, we have given ourselves another major shock, with the introduction of the goods and services tax from July 1, and we may yet see yet another change before the year is out — a shift in the fiscal year from April-March to January-December. Then there is the new job given to the RBI by the government — of forcing a resolution of bad loans, now edging towards Rs 8 lakh-crore.

Patel got a lot of criticism for the thing he was not responsible for: Demonetisation. It was a political decision, an executive decision, and those who disliked the NDA government for various reasons wanted Patel to exercise his independence and either criticise the government or manage the process of remonetisation unilaterally. This would have been the wrong thing to do, and Patel took the flak stoically and refused to be a dissonant voice that could have damaged confidence in the economy further. Despite the RBI’s small missteps in the November-December period, this was actually Patel’s finest hour, as the central bank managed the whole process of normalisation in four months.

But the allegation that Patel was some kind of government lackey probably got to him, and that is when he veered off in directions that have not been helpful to the economy or his reputation. In particular, the MPC’s decision in February to shift monetary policy from “accommodative” to “neutral” needlessly circumscribed the RBI’s freedom to act fast to cut rates if inflation showed signs of significant easing. Having prematurely shifted the monetary stance, the next two policies in April and June were delusional. Even as both retail and wholesale inflation were crashing, the RBI sat tight, with the chief economic adviser famously excoriating the central bank for its large “forecast errors” that were “systematically one-sided in overstating inflation”.

Let’s be clear. The problem we now face, post the economic shocks of demonetisation, the good harvest, the decision to force banks to take large losses by pushing big corporate defaulters into liquidation, and the slowdown precipitated by the shift to GST (which will blight sales in two quarters, April-June and the current one) is not inflation. It is disinflation and possible deflation (a situation where prices start falling in absolute terms).

Given a choice, in a poor country like India it is always better to risk inflation and opt for growth than risk deflation, which will destroy jobs and growth. The RBI needs to course-correct, and the August policy needed to see a sharp cut in rates by at least 50 basis points (that is, one half of one per cent). But the MPC and Patel have flunked the test by cutting rates by a niggardly 25 basis points.

It’s a pity that the governor is fighting the last war (inflation), when the next one — slowing growth — is upon us.

R Jagannathan is editorial director, Swarajya magazine

The views expressed are personal