The contrast in monetary policy dilemmas faced by two central banks couldn’t be sharper. For the US Federal Reserve, sustained growth and the unemployment rate falling to a seven-year low of 5.1 per cent last month would logically point to the need to start raising interest rates. It is quite the opposite for the RBI. A protracted investment slowdown and warnings by Chief Economic Advisor Arvind Subramanian last week about the Indian economy being closer to “deflation territory” would ordinarily call for a sharp cut in interest rates. But the dilemmas inherent in taking what should be common-sense decisions only underline that these aren’t ordinary times.
Raising interest rates isn’t easy for the Fed when global median inflation is running below 2 per cent, while remaining below that targeted level even for the US. Can the US afford higher interest rates when much of the rest of the world is in deflation mode, and the central banks in Europe, China and Japan are looking at further monetary easing? The RBI can similarly point to the dangers of slashing interest rates now, when the monsoon has turned out to be deficient and its effects are already being felt in rising onion and pulses prices. Moreover, foreign institutional investors have, since July-end, pulled out some $3.25 billion from Indian equity and debt markets. Wouldn’t lowering interest rates trigger further outflows, more so in the event of the Fed opting to hike its funds rate for the first time since December 2008
On closer examination, though, there shouldn’t be any real monetary policy dilemma for the RBI. Whether or not the government’s GDP estimates capture it, the Indian economy is still sputtering and little or no worthwhile investment activity is happening. Even on inflation, the estimates based on the wholesale price index and the more accurate GDP deflator show them at near-flat or even negative levels. The problem is only because of the RBI being guided by consumer price or CPI inflation, which was 3.8 per cent in July and may well go up in the coming months on the back of a not-too-good kharif harvest. But the RBI needs to relook at relying solely on CPI inflation, especially when this index has very high weightage for food. Given the inherent volatility in food prices, there is a danger of losing sight of generalised deflationary pressures that the CPI may not adequately capture. In an overall deflationary situation — both globally and increasingly domestically — the RBI’s current monetary policy stance, if sustained, would only further hurt growth, which is not going to help the cause of attracting FII inflows either. Monetary policy isn’t science. It is more about judgement which, in today’s context, dictates a sharp lowering of rates.