Opinion Caution is good

RBI does well to keep its focus on targeting inflation in the long term.

October 1, 2014 12:00 AM IST First published on: Oct 1, 2014 at 12:00 AM IST

As expected, the Reserve Bank of India has left its key rates unchanged in its latest monetary policy statement. In doing so, it has signaled a seriousness of intent in targeting inflation over the longer term. This intent, and the RBI’s hawkish stance in spite of the recent surge in growth and lowering of inflation, is welcome.

Though CPI inflation has eased from a high of 11.2 per cent in November 2013, there are significant variables that could upset the existing headwinds. Food inflation remains stubbornly high and could be exacerbated by a deficient monsoon in the coming months.

Emerging economies and India, in particular, have seen a surge in capital inflows. This is due in part to the slow rate of growth in the EU and the US over the past few years. To encourage higher growth, the US Federal Reserve has followed unconventional and loose monetary policies. With growth momentum picking up in the US, however, there is an expectation of a rollback of such policies in the near term.

If the US Fed raises interest rates, investors will prefer exiting emerging markets like India and going to the US. The current weakening of the rupee is an indication of the volatility this may cause. Then, international commodity prices, particularly the price of oil, currently near an all-time low, have helped in narrowing the current account deficit, which has shrunk to 1.7 per cent of the GDP from 4.8 per cent a year ago, and also lowered the input costs of various goods, leading to a softening of domestic prices.

This is, however, subject to change. International crude prices are impacted by political stability in the Middle East and Russia. Gold imports are also expected to pick up. The CAD could, therefore, get bigger by the end of the year.

It would be distressing if the RBI has to resort to exchange rate management if things start going downhill. In an indicator of its willingness to do so, the RBI has been amassing foreign exchange reserves. This should, however, be a last resort. Last year, the government took a number of retrograde measures to combat the volatility in financial markets owing to expectations of a dialling back on quantitative easing.

It is debatable whether those steps actually helped prevent volatility. Importantly, some restrictions, such as high duties on the import of gold, still stand. The RBI should, therefore, maintain its current stance of being cautious about easing rates and focus on a long-term low inflation rate.