Afterthought

The Right Step by RBI

The Right Step by RBI
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The central bank’s caution in reducing rates is valid

THE WIDELY EXPECTED reduction in the Reserve Bank of India’s policy rate finally took place on August 1st when the bank’s Monetary Policy Committee (MPC) decided on a 25-basis- point—quarter of a percentage point—lowering of its repo rate from 6.25 to 6 per cent.

There had been speculation for a while that India’s central bank would reduce its policy rate. But as with any other central bank, the RBI has a reputation for caution in conducting monetary policy. The case for treading carefully while easing credit availability has a sound basis in India’s macroeconomic history.

Two factors lie behind this conservative approach. One, in India it is tough to forecast inflation meaningfully. This is best exemplified by the volatility in the RBI’s own figures on inflationary expectations. Two, once inflation breaks out, it requires extraordinary steps to control it. In a country with inbuilt inflationary pressures—due to various reasons related to demand as well as supply—it is natural for the monetary authority to worry about excess cash stoking prices upwards at some point in the future.

Critics of the RBI say that this single-minded focus on price stability works at the cost of economic growth. This charge is dubious: there is evidence that tepid growth has its basis in spheres of policy other than monetary. If cheap money could buy manna, the Indian economy would have touched stratospheric levels by now.

So what enabled the RBI to go for a mild reduction? In recent months, there has been a sustained decrease in prices. A few agricultural commodities are now undergoing a deflationary trend. If one excludes food and fuel prices, retail inflation is at 4 per cent—which is within the RBI’s zone of safety.

This factor, on its own, would not have led the bank to loosen policy. What probably clinched the issue was two successive good monsoons and the even geographic spread of rains this year across India. This will help ensure that food prices do not spike later in the year, which could complicate the task of managing the economy. Further, in spite of the shrinking share of agriculture in India’s economic pie, weak demand arising from this sector often results in a spell of weakness in the overall economy.

There is no reason to worry about that right now.