Monday, January 28, 2013

C’mon Governor….take the leap of faith….be a hero

Today, the Governor of RBI, Subba Rao will again face thousands of expectant faces when he announces his twice-a-quarter monetary policy. Expectant of a rate cut. Expectant of a cut in CRR. Expectant of a little balancing of priorities of the RBI. And expectant that the head of the central bank will join hands with the Finance Minister in putting the economy back on the rails. But will the Governor oblige? Or will he continue to in his boring, predictable style?

If one were to go by past trends, the Governor won’t cut rates. Subba Rao has followed only one mantra during most of his Governorship: inflation control. And while no one can dispute the importance of this for any central bank, one cannot also forget that the central bank has a major role to play in stimulating economic growth. If economic growth was not an objective, the job of the RBI would be childishly simple. Just keep increasing rates, and eventually the inflation will come down. The best central bankers however are tested on managing the balance between low inflation low and stimulating high economic growth. Subba Rao’s performance appraisal should also factor in his efforts at stimulating growth.

If Governor Rao looked at data a little objectively, he might realize how much precious time he is wasting. Consider this:

a)    The Governor last decreased repo rates in April 2012. Since then, Wholesale Price Inflation increased for a short while (he would like to believe in response to the rate drop), but within a few months, the inflation started to drop.
b)    The diesel price increase of September last year – by a whopping 12% or so – had no long term impact on WPI. It has kept dropping, and has now reached a near 3-year low. So if the Governor was worried that the government’s recent diesel de-regulation could spook inflation, he needn’t worry.
c)     Since the time he has been increasing rates (13 times before April 2012), the GDP growth has fallen drastically. In the last three quarters, growth has been below 5.5%, a level not seen in India in the last decade (almost). The RBI Governor himself has lowered the growth prospect for this year and the next. Surely, this must play on his mind?
d)    Core inflation – or manufacturing inflation – has been at less than 5% for quite some time now. Manufacturing has a weight of 65% in the calculation of overall inflation. Governor Rao knows that his rate controls work most effectively only in the manufacturing sector. In the other two components of inflation – fuels and food – the influence of rates on pricing levels is tenuous. Surely if core inflation is down so much, the RBI should be a little relaxed?
e)    A few months back, the Governor had said that he would wait for Chidambaram to take steps to take steps to control the fiscal deficit. Well, Chidambaram has gone farther than most people anticipated. He has de-regulated diesel, gradually for retail buyers, but immediately for bulk buyers (a really smart move, and one hardly noticed). The railways has increased fares, for the first time in a decade. Power utilities are increasing rates like never before. Chidambaram has laid out a 3-year fiscal roadmap which should see fisc deficit go down to some 3% of GDP by 2016. For the current year, he has re-assured us that fisc deficit will be kept lower than 5.3%, a figure no one believed even a few months back. Surely, Governor Rao should now play his part?

The fact is that inflation – especially consumer inflation which is in the double digits – is largely led by fuel and food prices. Fuel prices needed a correction, and now that that has been done, it should help contain inflation in the long run. With respect to food prices, the reason is actually more buying power in the hands of the poor, with NREGA and higher MSPs to farmers and generally better distribution of wealth. I have consistently argued that a higher overall inflation level, with a low core inflation, should not be seen as a problem. The pain the urban middle class faces is because for the first time, the rural poor are partaking of the food production. This is proven by the fact that it is protein-based foods (eggs, non-veg, lentils) etc that have seen high inflation, not cereals. As the poor have more money in their hands, they are finally getting more nutritious food to eat. The middle class should be willing to bear this pain.  

The other way to look at this issue is to ask when (eventually) will the RBI lower rates, if not now? Will it wait for inflation to come down to 5%, even if that means the GDP growth slips to an even lower number? The RBI Governor cannot be so clerical. He has to experiment. No model in the world has been developed for India’s unique conditions. For all we know, our model may well become the benchmark for the world.

The real truth is that the economy is waiting for action from the RBI Governor. And he has to oblige. In fact, he must drop rates by 50 basis points. He must signal his support for the Finance Minister’s efforts. If thing boomerang, he can always reverse course. But being predictably conservative helps no one….

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