Pause,and then?

The RBI opted to wait and watch before taking any action on monetary policy. This was perhaps the only sensible option in the current uncertainty. With inflation and inflationary expectations still higher than RBI’s comfort level,it was right not to cut rates despite the clamour from industry. Real interest rates are still negative,and unless inflation comes down,there is a danger the wage price spiral could continue to push inflation up. Core inflation,consisting of the Wholesale Price Index excluding food and oil prices,is still high — something the RBI would need to watch before cutting rates.

Industry wants both an interest rate cut and a strong rupee as many companies have borrowed in dollars or have imported inputs. But an interest rate cut would also put further downward pressure on the rupee. This would be inflationary and something the RBI would want to avoid. After standing firm on allowing the rupee to be flexible for many months,the RBI has recently stepped in with a number of capital controls on derivatives markets that aim at preventing further rupee depreciation. While capital controls are known to have had a short-term impact and may stem the depreciation,they usually fail in the long run. So,if the rupee’s movement is based on weak fundamentals of the macro-economy,the RBI would end up pushing rupee derivatives markets to offshore markets.

The case for pausing monetary tightening primarily arises due to the IIP data showing a decline in output for the first time in many years. A slowdown has been on the cards since the 2008 crisis. Investment continued in projects already underway,but the uncertainty in the global environment made entrepreneurs reluctant to announce new investment projects. Is easing monetary policy a good option going ahead? One of the big dangers of easing monetary policy in today’s high inflationary expectations environment is stagflation,a situation of slow growth and high inflation. If the present policy paralysis in the government remains,if governance issues are not solved,if populist policies continue to dominate,if the subsidy programmes run the fisc to the ground,if the mood of business pessimism remains,will business start investing merely because interest rates are cut? It seems unlikely. Today,the fundamental weaknesses in the Indian economy and polity are too big for monetary policy to solve. The RBI should exercise extreme caution before trying to use monetary policy to expand output in this adverse environment.