RBI monetary policy: It’s time to change three gears

Indranil Sen Gupta, Economic Times 25/1/2012

source: http://articles.economictimes.indiatimes.com/2012-01-25/news/30662952_1_forex-reserves-monetary-policy-policy-rates

We welcome the Reserve Bank of India’s growing focus on protecting growth from fighting inflation. Monetary policy should change in three ways. First , policy rates need to cycle down to support growth. Second, RBI needs to reduce the money market liquidity deficit to ease pressure on lending rates instead of adding to it.

Finally, we expect RBI to rebuild forex reserves instead of strengthening the rupee to fight imported inflation. We are relieved to see governor Subbarao signal a possible rate cut in March. In fact, growth is flashing red lights: loan demand has fallen to 17% from 21.4% in March 2011 and December GDP growth will likely slip to 6-6 .5% levels.

After all, India is perhaps the only economy in the world in which lending rates have pierced their 2008-peak . What about inflation? We agree with RBI that the present relief could be temporary . In fact, we expect inflation to rebound in mid-2012 after the government hikes coal, oil and power prices.

Flagellating ourselves by killing India’s growth, however, will not pull down global oil prices. Not surprisingly, every other BRIC central bank has been easing already. We are quite confident that core inflation (ie, inflation adjusted for weather, oil and metal price shocks) will come off. With growth falling below the economy’s potential of 8%, corporates are losing pricing power.

Can we get past the mid-year rebound in inflation? One way could be to hike oil prices on Budget day itself. Sure, this will push up inflation by about 100 bps to 8% by March 2012 from our base case. Yet, markets will then see inflation falling straight to 5.5% in March 2013. This will also allow RBI to steadily cut rates without fearing a rebound in inflation.

We are happy that RBI cut CRR by 50 bps to bring down money market liquidity deficit to ease pressure on rates. In fact, we hope that it later buys more government paper via OMOs to bring the money market liquidity deficit to its targeted Rs 60,000 crore from Rs 1,50,000 crore now.

After all, monetary growth, at 16.5%, is running below the optimal 17.5% levels consistent with 8% growth. Finally, we expect RBI to revert to building up forex reserves as insurance cover . After all, the import cover (ie: months of imports that forex reserves can fund) has fallen to 7.7 months, the least since 1997.

We appreciate that RBI could not buy forex reserves because it was trying to fend off imported inflation with a strong rupee at a time of high current account deficit. But, the recent crisis has shown that high forex reserves help as markets respect the fact that the Reserve Bank carries a big stick. The RBI must, at the earliest opportunity, recoup the $45 billion it has sold since 2008.

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