Why is RBI chief Subbarao so cynical?

May 6, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

In its policy review on May 3, the Reserve Bank of India (RBI) did bring down the repo rate by 25 basis points but it also presented a gloomy outlook on growth and inflation which left the stock markets cold. The Sensex, which had surged in anticipation, fell 160 points. What makes the RBI so negative when even rating agencies are inclined to accept the emergence of green shoots?

RBI Governor Duvvuri Subbarao has himself spelled out the risks. “Upside risks are still significant in view of sectoral demand supply imbalances, the ongoing correction in administered prices and pressures stemming from increases in minimum support prices,” he said. Is Subbarao’s risk assessment genuine or has it been exaggerated to put the government under pressure?

Sectoral imbalances may take time to fully correct but if as anticipated by the India Meteorological Department the monsoon this year is normal, the supply deficit will be considerably reduced. It is quite likely the correction in administered prices may also be downwards rather than upwards with international commodity prices, including that of crude oil, moving south.

But there is certainly the risk of an increase in minimum support price, which has been the cause of inflation creeping upwards. The increase in food grain support prices each year has become a source of inflation with the potential to spread throughout the economy. First, there is the direct effect. A 5 percent increase in prices can lead to inflation going up by 0.75 percent. Second, there is the derived effect. The increase in support prices is reflected in the cost of living and consequently wages, raising the cost of manufacture to push up inflation by 1.3 percent. The direct and indirect effect of a 5 percent increase in support prices adds 2 percent to inflation. This is a genuine risk but not too significant.

Surely there are risks of inflationary pressures but these have apparently been exaggerated by an RBI possibly expecting the government, which is keen on interest rate reduction, to take supplementary measures. Even so, the RBI monetary policy need not have been unduly restrictive and the outlook unjustifiably gloomy.

What is critical is inflation should not be the single policy target. Growth and employment are other objectives and to accommodate these, the repo rate should not be in excess of the inflation rate. After all, the repo rate is addressed to commercial banks. The rates charged by the latter to the borrowing public are in excess of the repo rate by at least 200 basis points.

No wonder many central banks, including the European Central Bank, no longer go by inflation alone but mould their policies to stimulate growth and employment. Hence, their repo rates are close to or even less than the inflation rates. The RBI has been too conservative and as a result, the country has lost growth and employment without keeping inflation within a tolerable limit.

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