Monetary tightening has raised downstream costs, in manufacturing for instance, contributing to the very inflation it is meant to combat.
Dr D. Subbarao, the new Governor of Reserve Bank of India seems to have assumed office under auspicious circumstances, going by recent economic data. The Wholesale Price Index has dropped to 12.10 per cent last week from the high of 12.66 per cent three weeks ago. It is too early to presume that yet another fortuitous event, the softening of crude prices to around $ 100 a barrel, will have a beneficent effect on domestic prices. At home, the rupee has weakened to below Rs 45, the lowest in 21 months. This fall has been accompanied by a greater outflow of FII funds, a feature that will not be bemoaned by the central bank, exercised as it has been by the pressures of sterilising surging inflows last year. Industrial production in July, with a 7.1 per cent growth, reversed a five month downtrend, with capital goods leading the way. So what do the trends bode for monetary policy?
The new Governor has made it clear that inflation is still the main concern. But the current inflation has multiple causes. Dr Subbarao adds a new dimension by locating it among others, in supply constraints brought by a consistent high growth. Global inflation is of course well recognised. Demand pressures have equally influenced the monetary tightening of the last two years. Underlying this policy is the notion that the economy is still overheated as reflected in strong credit growth and excessive money supply. While credit growth this fiscal has been stronger than last year, it has declined from three years ago. On the other hand, investment demand has been fairly robust over the years. So demand pressures must emanate from an entirely unexpected source; the latest annual report identifies it in passing: government borrowings for off-budget spending.
Dr Subbarao must examine the perverse effect of dear money on “monetary accommodation” of the government. That is not all. Monetary tightening has raised downstream costs, in manufacturing for instance, contributing to the very inflation it is meant to combat. Capital inflows also impact current inflation, as the annual report reminds us. But restricting the flow is not the answer; easing capital controls over those large reserves and allowing the currency to appreciate would cheapen imports and reduce money supply to tolerable levels. Staying the hand of government over market funding is another matter; the central bank has to manoeuvre monetary policy within public policy and sometimes they may clash. Letting the rupee appreciate makes eminent sense if the interests of a larger constituency are to be protected.
