Price stability comes first for the RBI

July 22, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The job of a central bank is not enviable, at least not in a growth-obsessed economy like India. When it does not get hawkish enough, it gets termed as being “behind the curve”, and when it does get hawkish, we implore it to stop for fear of hurting growth.

The Reserve Bank of India (RBI) has been in a similar dilemma of late. On the one hand, rising inflation has forced it to raise rates, whereas on the other, industry captains (banks and business leaders) and certain sections in the government are calling for a pause in rate hikes.

What such people fail to recognise is the fact that growth is going to slow down anyway even if the RBI does not hike rates. High inflation brings down growth all by itself. Instead of asking the RBI to stop, one should think of ways to bring down inflation. There simply cannot be any trade-off between inflation and growth. The choice is clear — ensure price stability and growth will automatically come in an economy like India’s. For the central bank, price stability comes first and it should remain so.

Going back to the books, RBI has already raised rates 10 times starting March 2010, hiking repo rate from 4.75 pct to 7.5 pct and reverse repo rate from 3.25 pct to 6.5 pct. This makes it one of the most aggressive central banks in the world in terms of fighting inflation.

The fact that despite this inflation has refused to come down, points to the structural nature of inflation. The journey that began with high food price inflation in 2009 has culminated in high wage inflation which together with rising input prices, has led to a spike in prices of manufactured goods. And this is what the RBI is most worried about.

To add to woes, questions are being raised on the quality of inflation data that is being doled out. There have been consistent upward revisions in WPI inflation figures since July 2010. Inaccurate data makes the job of a central bank even tougher.

Going ahead, we expect the RBI to hike rates further by 50 to 75 bps over the course of the next one year (including a 25 bps hike expected in the policy meet on July 26). Manufacturing inflation is picking up (has risen to approx. 7.5 pct), commodity prices refuse to come down (crude prices are back above $95/bbl) and possibility of another round of quantitative easing in the U.S. (QE III) is emerging. Amid all this, we expect RBI policy stance to remain firmly hawkish/anti-inflationary at least in the near term.

Growth is indeed getting hurt in this process as can be seen from the deceleration in GDP and industrial output growth as well as moderation in the pace of credit growth. But inflation is yet to be tamed. Over the past year, most forecasts (including forecasts from some of the most eminent economists and policy makers) calling for a peak in inflation have fallen flat. The question now facing the RBI is price stability or growth? It seems to be going ahead with the former.

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