RBI announced its review of monetary policy yesterday. In its review, RBI stated that "upside risks to inflation have increased from the recent surge in crude oil prices, fiscal slippage and rupee depreciation". Further, while indicating a bias towards lower interest rates in future, it refrained from cutting interest rates immediately, citing risks to inflation, in spite of marked slowdown in the economy.
Consumer inflation in India has eased significantly in last nine months and continues to be on a structural downward path due to demand compression. RBI has done well, finally, to identify fiscal slippage as a key cause of elevated inflation observed in India over the last three years. However, its actions on this front are inconsistent and harmful to long-term health of Indian economy. For last several months, RBI has been conducting OMO purchase of government bonds purportedly to support banking liquidity, while actually supporting yields on long-dated government bonds. From 1st April 2011 till 3rd March 2012 RBI conducted OMO purchase of Rs. 1.2 trillion, mostly long-dated bonds. This is a record amount of intervention by RBI. If RBI really believes that fiscal deficit is a cause of inflation, it should not be buying government bonds outright. The provision of liquidity for orderly functioning of banking system can be done through enhanced volumes of overnight repos. In other words, there is inconsistency in RBI's refusal to cut policy rates due to fear of inflation caused by fiscal profligacy, while supporting fiscal profligacy by conducting unprecedented OMO purchases.
Now, coming to the crude oil prices as a cause of inflation, we would like to make two observations. Firstly, crude oil price dynamics is more or less similar for all energy importing countries. Other Asian energy importers, notably China and Japan, face significantly lower consumer inflation than India under all conditions of crude oil prices. Hence, to numerically state that Indian inflation is caused by energy prices smacks of intellectual laziness on part of Indian policymakers. Secondly, it is a well-proven fact that to keep policy rates higher than desired to counter external supply shock (and vice-a-versa) is a pro-cyclical policy prescription, leading to more pronounced economic cycles. A central bank looking to follow a policy path to smoothen economic cycles should be cutting interest rates in the face of an external supply shock and raising interest rates when the supply shock disappears.
Finally, coming to Rupee depreciation as a cause of inflation, we believe that the RBI has its analysis plain wrong, although numerically it is right. Rupee, on REER basis is quite strong, in spite of nominal depreciation. While numerically one can show that if Rupee were to hold on its nominal levels for last one year, imported inflation would have been lower, this analysis misses the fact that due to relative inflation levels, India is becoming less competitive externally due to the inadequate depreciation of the Rupee. This loss of competitiveness will lead to lower investment in productivity enhancing infrastructure, which in turn will lead to higher inflation in the future.
In all, the jury on effectiveness of RBI’s policy is still out. We would have preferred much lower policy rates and significantly higher government bond yield spreads to policy rates. This would have chastised the profligate government, without harming the private sector.