The Reserve Bank of India will announce its monetary policy this week. While there has been talk about the RBI reversing its monetary policy stance, and reasons why it should start tightening, to do so now would be a mistake. It is too early to tighten. Real interest rates remain high, uncertainty continues to prevail and investment announcements have shown a dip, spelling bad news for the months ahead. Further, consumer price inflation has slowed down in the last quarter, despite some rise in food prices. The world economy is still beset by prospects of shrinking and inflation will not see a serious upsurge as long as demand remains weak.

While for international investors it may make sense to think of India as one of the fastest growing economies in the world, what is pertinent for policy is to compare the Indian economy at present against that last year. Even though India continues to witness GDP growth of 5-6 per cent, the drop that we have witnessed in a year, of more than 400 basis points in the growth rate of GDP, is comparable to the drop witnessed by many developed countries.

Monetary policy for the coming months should be guided by a prediction about demand conditions in the Indian economy. These are still showing signs of contraction, and the fiscal stimulus has not been enough to counter this contraction.

The arguments in favour of reversing the expansion in the RBI’s monetary policy stance of October 2008, and thereafter, are based mainly on the expansionary fiscal stance. The expansion in the fiscal deficit from 6 per cent of GDP in 2008-09 to 6.8 per cent of GDP budgeted for 2009-10 is an expansion of 0.8 per cent of GDP. But this does not translate into an expansion in aggregate demand. When we analyse aggregate demand, the situation appears quite dismal. Investment demand has fallen sharply, as seen in the contracting purchases of capital goods. Both production and imports of capital goods have been shrinking. Note that this is not merely that their growth rate is declining. It is actually negative.

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