Putting monetary policy in context

A view of the Reserve Bank of India.

The Reserve Bank of India (RBI) will unveil its next instalment of the bi-monthly policy review on February 3. Like all policy statements, this one too will have a significance of its own. As always, the context is important. The Union Budget — the first full budget of the NDA government — will be presented to Parliament on February 28, less than a month after the RBI review. Not just the RBI but everyone else will be looking at the way the new government is handling its finances. 

Fiscal and monetary challenges

The commitment to rein in the fiscal deficit at within 4.1 per cent of the GDP by March this year will be scrutinised from all sides — not just the achievement of the admittedly challenging target, but the ways in which it has been achieved. For the monetary policy itself fiscal consolidation has been a highly desirable, even a necessary goal. In the battle against inflation, the government has an equally important role to play as the RBI. In the broadest sense, it is neither the inflation numbers nor the deficits — important as they are — but the growth expectations from the economy that matter the most. 

The monetary review and the Budget and related documents will have their say on India’s GDP growth rates. Right now, both the RBI and the government estimate the current year’s (2014-15) rate of growth to be around 5.5 per cent, below what most international institutions, including the IMF and the World Bank, estimate it to be. 

Turning to RBI policy review, there is another reason why the customary feverish speculation on whether there will be a rate cut or not is singularly absent this time. The RBI has initiated an easing monetary policy by reducing the repo rate from 8 to 7.75 per cent on January 15. , a little over two weeks before the scheduled review (on February 3). 

A rate action before the scheduled policy review was not unanticipated. This was consistent with the forward guidance given by the central bank in the December policy statement. 

The reasons for the monetary softening have been well documented. They include softer-than-expected consumer inflation (retail inflation as measured by the CPI index); and broad-based disinflationary tendencies, particularly in core and even food inflation. 

Retail inflation at 5 per cent in December was well below the RBI’s January target of 8 per cent. There has been a 50 per cent slide in crude prices since June. Household expectation of inflation is significantly down. All these appear to have convinced RBI that the momentum of inflation is finally waning. In fact, even the January 2016 inflation target of 6 per cent looks eminently achievable. However, even as the RBI shifts emphasis to supporting growth, its focus on inflation can never waver. Further, rate cuts during the year might depend upon how well the government progresses on the fiscal front and the support it gives to reviving industrial activity. Falling inflation has given room for further easing but the central bank is likely to be cautious going forward. 

Stock markets

There is one big area of concern to policy makers. Going by the phenomenal rise in the stock indices, Indian markets have never had it so good. As on last Tuesday (January 27), stock market indices set new records for five days in a row. By most yardsticks, Indian stocks are overvalued. Yet, foreign money has been pouring in — with FIIs, the largest of the institutional investors, investing some $1.5 billion in the previous eight sessions. 

Amid such exuberance, a word or two of caution will not go down well. But this is the time most investors have to be especially wary of sales talk and newspaper headlines. Also, the reasons behind this hype need to scrutinise for what they are worth. 

For instance, it would seem unpatriotic to pick holes in the apparently win-win situation following President Obama’s visit. Yet, at the time of writing this, nobody is clear on the liability aspects in the civilian nuclear agreement. 

Take another example: the widely quoted observation of the IMF-World Bank that by 2016 India’s rate of growth will outpace that of China, making India the fastest growing major economy. Welcome as such a development would be, China is consciously winding down its growth process. 

Moreover, China’s economy is several times bigger than India’s. That makes a comparison on the basis of percentage growth rates highly misleading. The short-point is that stock market investors need to be prepared for a soft-landing. 

RBI’s credit policy review might be the right forum to begin that exercise. After all, the RBI has always been cautious — highlighting the risks to a higher growth as well as lower inflation. It is these areas that should command maximum attention in tomorrow’s policy statement.