RBI in its policy review opts for flexible policy financial scene

The Reserve of India’s in its third quarter monetary policy review did not change any of its policy rates — the Bank Rate, the repo rate and the reverse repo rate and this has become the focal point of discussion on the subject. RBI has not touched the cash reserve ratio, while the central bank has clearly chosen status quo in so far as interest rates are concerned. Whereas individual banks, have been urged to lower lending rates. Moral suasion helps up to a point while even overt signaling devices, for instance a reduction in CRR or repo rate, need not always work.

While as a rule public sector banks, are following the suggestions, especially if they come from the Finance Minister. In mid-October last year on one widely publicized occasion, the Finance Minister had convinced banks to reduce their interest rates on car loans. To give respite to auto sales was given as the reason for the intervention.

May be such instances will become part of history as they do not leave good impression on the autonomy of the monetary authorities.

At present the Finance Minister has publicly authorized the RBI’s stand of not changing the policy rates. Functional though it may be, but it does give the central bank the flexibility to increase or decrease the rates depending on the emerging domestic and global situations. Moreover, through a conscious decision, the RBI wanted to convert monetary policy statements into ‘non-events’. Even though increasing the frequency of policy statements from two to four in a year, the central bank had made it clear that it is not necessary making rate changes will be always be a part of each policy statement. Such de-linking gives flexibility to the central bank.

However, on the eve of its latest policy review, there were more assumptions than the usual level as to what the RBI would do with its rates. Most of them thought that it would reduce the rates, for this there were several reasons why their expectation was not baseless.

Week ahead to the central bank policy review, the U.S. Federal Reserve (Fed) had cut its federal funds rate by a massive 0.75 percentage points mainly to encourage the U.S. economy that was seen as sliding into a recession. On stock exchanges prices had crashed across the globe. As the result of the rate cut, there was some recovery but that proved short-lived. On January 30, after the announcement of the RBI’s review, the U.S. Fed further reduced the fed funds rate by another 0.50 percentage points.

Such massive interest rate reductions done by U.S. Fed have several implications for India and other emerging economies too. Many of them among a large section of market analysts had expected that other countries, including India, will follow suit, perhaps not to deflect a decline as in the U.S. but to remain competitive and encourage growth.

In India, economic growth continues to be strong but there are signs of a slowdown in manufacturing and to a lesser extent in services. For the current year almost all recent gross domestic product (GDP) forecasts have been less cheerful giving signal that the second half of 2007-08 would see a much slower growth than the average 9.1 per cent recorded in the first six months. It was thought that two sectors, consumer durables and transportation equipment, which have been slowing down and an interest rate reduction in India, will help in their recovery. Though not changing of interest rates looked equally strong but were based almost entirely on considerations of price stability. Inflation, which has always been a major worry for most central banks, is right back at centre stage of monetary policy.

However inflation numbers has been below 4 per cent but rise can been seen in the recent weeks. Globally, oil prices are going to remain high though Indian consumers continue to be insulated. Then there is the ‘food inflation’ caused partly by record prices of wheat, corn and other cereals.

There has been growth in the money supply and bank deposits, ahead of targets while non-food credit from banks is sharply lower. The surplus of liquidity is a cause for worry. The RBI is hoping to hold inflation within 5 per cent this year and anchors expectations in the region of 4-4.5 per cent over the medium term.

As always, the RBI have to tackle several — often conflicting — objectives simultaneously. Maintaining price stability while providing for the credit needs of the economy has always been a dilemma. There is also the question of balancing short-term considerations with those of the medium term. The RBI has been clearly indicating that the complexities of monetary management are such that there is a requirement of substantial flexibility to deal with the emerging situations both in India and abroad. What’s more, fiscal policies should supplement monetary policies even for achieving monetary goals.

For instance, steady accumulation to the RBI’s forex assets has contributed to the huge growth in reserve money. A major portion of the assets build-up is owing to large portfolio investments in the stock market. The RBI’s actions of first sterilizing the dollar flows and then trying to clean up domestic liquidity — through market stabilization schemes and so on — are the classic monetary policy fix. Fiscal policy obviously comes into play in several ways. The debate over better utilization of forex reserves cannot be done in isolation from the quasi-fiscal costs that are incurred in keeping the reserves in safe, but low yielding instruments such as U.S. government paper.

Lastly, the RBI in sticking to its GDP growth target of 8.5 per cent for the current year, is not necessarily conservative. Days after the monetary policy review, the Finance Minister, is expecting the economy to grow at closer to 9 per cent which will be not substantially higher than earlier official forecasts.