Opting for second best

The Reserve Banks decision to retain the status quo on key policy rates in its monetary policy statement is a second-best policy response. The best policy response in the current economic environment would,of course,have been to cut rates. But there was a scenario,even if the probability of it happening was minute,in which the RBI could have decided to hike key rates particularly if recent noises from the central bank about inflation being a matter of concern were an indicator of the its thinking. That would have been much worse than the second best response we eventually got.

The case why rates should be reduced further has been made often enough in these columns. It is still too early to proclaim an economic recovery,even if the overall growth expectations have improved over the last few months. Industrial growth may have turned positive but it is still anaemic. The RBIs own statistics show that credit to key sectors,like SMEs which have borne the brunt of the slowdown,is a lot lower this year than it was last year,when measured in absolute amounts. Retail loans for housing and automobiles have also registered a steep decline compared to last year. Most critically,bank lending rates,as measured by the prime lending rate,are still in double digits. If one adds a negative rate of inflation as measured by the WPI,the real rates of interest are even higher. Curiously,there continues to be a large disconnect between the RBIs repo rate and prime lending rates. In fact,the last time RBI policy rates were this low,prime lending rates were much lower.

Given this scenario,the RBI should certainly have considered a cut,even if a nominal 25-50 basis points,to send a strong signal to banks and industry that the RBI wants credit to flow more freely and,importantly,more cheaply into the economy. It is true that inflation measured by the consumer price index is high at just under 9 per cent. But that is largely because of a steep rise in food prices. This is a supply side phenomenon and has little to do with excess demand. Interest rates are an effective instrument against inflation when inflation is caused by excess demand. The RBI has done well to hold off against excessive hawkishness on inflation. But it could have done better.