RBI walks tightrope between lower growth and rising inflation

In theory, this is an invitation to move spare funds to the RBI, leaving banks with less money to lend to the market. This is meant to mop up excessive liquidity which spurs on inflation.

It is interesting that while the central bank has lowered its growth forecast, it has opted to focus on fighting inflation instead of kick-starting growth. Experts point out that the move is more a signal that the RBI will continue its tight monetary policy 8212; and perhaps even raise interest rates in the future 8212; than an immediate cure to the problem of rising prices.

8220;Much of the liquidity has already been sucked out of the system over the past couple of months,8221; said Crisil economist D K Joshi. The RBI had done this by raising the Cash Reserve Ratio CRR, which is the proportion of their deposits that banks must park with the RBI. The more that banks place with RBI, the less they can lend.

This has had an immediate fallout. Banks usually park their excess funds in repo balances. They have now had to divert them to fulfil their CRR targets, which means this money is no longer available for lending.

RBI8217;s own figures indicate that the daily repo balance fell from Rs 41,460 crore on September 14, the day after RBI announced the CRR hike, to just Rs 4010 crore on October 23.

When the central bank moves to fight inflation by reducing the funds available for lending, and investing, it can unfortunately dampen growth in the process. However, analysts believe that given the clear upswing of a business cycle, the small rise in rate may not hurt investment. Finance Minister P. Chidamabaram shared this sentiment, saying that RBI8217;s measures would not affect the growth momentum.

On its part, RBI has lowered its growth projection by just half-a-percentage point from 6.5-7 per cent to 6-6.5 per cent. This assertions comes despite the poor monsoon and a tighter monetary policy.

Reacting to this, Chidamabaram said: 8216;8216;If monsoons are deficient by 13 per cent and global oil prices at 56 a barrel, one has to be realistic about growth targets.8217;8217;

Meanwhile, inflation could grow from 5 per cent to as high as 6.5 per cent, said RBI Governor Y.V. Reddy.

The current bout of inflation stems from the rise in the international prices of oil and metals and the custom duty cuts made by the central government.

These cannot directly be reined in by the steps that RBI has announced, so all that the central bank can do is to signal its intent to fight inflation, in case things go out of hand.

This is called curbing 8220;inflationary expectations8221;. And when people and market players believe that the central bank will step in to fight rising prices, the market moves in a manner that ensures that prices rise more slowly.

There was widespread fear that the RBI would hike the bank rate. With no rate hike coming, the Sensex8212;which fell 60 points on Monday8212; recovered by 70 points on buying support.

8216;8216;The growth in GDP is likely to be less than originally projected mainly due to deficient monsoon conditions and partly due to high and volatile oil prices, despite a better than anticipated outlook for manufacturing industry and export demand,8221; Reddy said.

The central bank made it clear that it would pursue an interest rate environment that is conducive to macro-economic growth and price stability and maintaining the momentum of growth.

8216;8216;While the Reserve Bank will continue to pursue stability, the markets should be prepared for uncertainties,8217;8217; the mid-term review said. 8212; with ENS, Mumbai.