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Rupee.Border.Thmb.jpg Rate hike - why RBI is wrong again?

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Writuparna Kakati | 25 Jan, 2011

As expected, the RBI has finally gone for more monetary tightening on Tuesday, raising its short-term lending and borrowing rates by 25 basis points - a move to rein in rising inflation but which could further slow down the nation's sluggish industrial growth, as experts believe.

With the apex bank's move, as it has been a common phenomenon these days every time a monetary policy review is released, difference over mix of fiscal and monetary measure comes into surface again - this time probably a little bit sharper with the trade minister Anand Sharma's comment a day prior to the policy review that while inflation is "definitely" a cause of concern, it could not be curbed by increasing interest rates; instead, there is a need to provide easy credit to the industrial sector for the development of industry and growth of the economy.

Last week, the trade minister had even written a letter to the finance minister Pranab Mukherjee saying that raising cost of borrowing "may not be suitable" tool to rein in inflation with industrial growth already plunging to an 18-month low of 2.7 percent in November 2010.

In fact, the RBI itself, while analysing the performance of the private corporate sector in the country, recently viewed that rising input costs and higher interest rates had impacted the profitability of the Indian industry during the first half of the current fiscal.

Indian exporters also  demanded that RBI should ensure that manufacturing and export sectors were insulated from any further hike in the interest rates while announcing the third quarter policy review. Just a day prior to the review, exporters' body FIEO said that the hike in cost of credit would be a set- back for the manufacturing sector, which has shown just 2.3 percent growth in November 2010.

The RBI, however, time and again made it clear that containing inflation would be the top priority of the central bank, which eventually raised the repurchase or repo rate to 6.5 percent from 6.25 percent and reverse repo rate to 5.5 percent from 5.25 percent while keeping other rates like cash reserve ratio and statutory liquidity ratio remained unaltered.

So, the question is - does the current economic situation of high inflation and high interest rates call for a change in the current mix of fiscal and monetary policies? The current mix seems to be a 'moderate' fiscal policy and 'tight' monetary policy with some of the fiscal sops given to the industry during the global economic slowdown still continuing, parallel to which the RBI raising its key lending rates six times only in the last year.  

With the gravity of the current economic situation, especially keeping in mind the rising inflation and the slowed down industrial and manufacturing growth and the concerns of the export sector with some of India's major export destinations still spelling uncertainty, it seems that the policy-makers need to give some more time to find out a right mix of fiscal and monetary measures.

The notion of 'policy mix' or the combination of the monetary policy and the fiscal policy is a crucial part of  macroeconomics literature, although seldom it generated controversy as it has now. Fiscal policies involves the use of government spending to increase demand and decrease tax rates to increases consumption. In contrast, monetary policies try to control the supply of money, often targeting the rate of interest. As a whole, the 'policy mix' should put the economy on the path of growth.

In the current economic scenario, with inflation shooting up and growth slowing down, and the central bank's inability to rein in rising prices even after a series policy-rate hikes, it seems that the government should rebalance the 'mix' - probably shifting gradually towards a 'tighter' fiscal policy and an 'easier' monetary policy.

Also, the Centre should shift its focus to the supply side policies, particularly to improve the farm sector output, which could be a solution to the rising food prices. In addition, improvement of transport and infrastructure, reduction of unnecessary red tape, lowering down of transaction costs, and creation of more skilled manpower will certainly help the economy and the industrial sector.   

The bottom line - there must be a close coordination between the government's fiscal policies and the central bank's monetary measures, unless which they could lead to nowhere. Parallel to a balanced mix of these policies, what is more important is to shift aggregate supply to the right and focus on improving the productive capacity of the economy.

(The author can be contacted at writu.kakati@gmail.com) 


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