Half measures

The Reserve Bank has hiked the policy interest rate by 25 basis points. While this is a move in the right direction,as long as the rate hike is less than the hike in inflationary expectations,the stance of monetary policy is expansionary as real interest rates have not been raised. Since the inflation forecast of the RBI has gone up from 7 per cent to 8 per cent,a move of 100 basis points,this suggests an easier stance of monetary policy.

While both fiscal and monetary policies are responsible for the present high inflation situation,the fiscal situation cannot turn out to be better than what it is estimated in the budget. The risk might be on the downside since oil prices may rise and the oil subsidy bill may be much higher than budget estimates. Unless the RBI believes that the fiscal situation will actually play out exactly as estimated,or may even be better,the policy stance will be easy. The other element of the monetary story right now is the tight liquidity situation in the market. Banks are borrowing at the repo window from the RBI on a regular basis. In this situation,a 25 basis point increase in the policy rate is seen as an effective increase unlike when there is an easy liquidity situation. But even though tight liquidity and small 25 basis point hikes have come to characterise RBI policy for many months now,it has not been effective in controlling inflation.

Will the 25 basis point hike be enough to bring inflation down? Unlikely. There has been a long and persistent build-up in inflationary expectation and an upward drift in inflation for more than two years. Full capacity utilisation with growing demand coming from high government spending characterise the Indian economy today. While the 25 basis point policy is a safe one,since it cannot do much damage,it is not safe if inflation is the biggest risk as it can pull down investment and growth and damage the Indian growth story. The weak transmission of monetary policy and long lags suggest the policy rate should have been hiked by more. The longer the high inflation stays with us,the greater will be the build-up of inflationary expectations and the harder it will be to get rid of them.