Monetary Signals ahead: Financial Express: 19th October 2008

RBI's action of reducing the CRR in three tranches from 9% to 6.5% is a clear indication of a system of changing paradigms that has been in vogue throughout the year. One will recollect that the RBI started the financial year with a series of increases in the CRR from 7.5% to 9% as many as 6 times between April 26 and August 30. The reason then ostensibly was that inflation was a concern and there was pressure to control the rate of growth of price increase. At that time, critics felt that inflation was a cost-push phenomenon and that removing liquidity from the system would not really help as long as the supply constraints remained. However, it was justified on the belief that potential demand-pull forces would be controlled through these measures and would address the broader issue of inflationary expectations. In a way it did not matter, as it was the traditional slack season when the demand for funds is low.
The policy of increasing the CRR and curbing liquidity however, had certain unintended effects in terms of the negative impulses seen on industrial growth. which has come down to less than 2% in August, which is now a concern. Projections for the same are less than sanguine, between 6-7%, now following the financial crisis from the number of 8-9% expected earlier. Also, inflation per se has not really been moderated and is only gradually coming down from the level of 12%, as supply fundamentals have improved. RBI is of course carefully tracking this variable before posting a comment on whether or not the worst of inflation is behind us. It may be waiting for the declining trend to continue before passing a firm judgment.
Now, the global crisis has exacerbated the situation, forcing RBI to lower the CRR to 6.5%. The trace of urgency is palpable because the three reductions have been with effect from the same date: October 11, as the crisis has intensified. There was a deficit of Rs 90,000 crore in the system as evidenced from the borrowings through repos in the market, which could not be covered by the 50 bps or the 150 bps reductions to begin with, which prompted the third round cut of 100 bps. The overall attempt to increase liquidity through reimbursements of farm waivers, opening the window for mutual funds, etc, are all targeted at making life morecomfortable. There are now hopes based on the u-turn of RBI that the repo rate will also be reduced going ahead.
Now, there are two issues, which come to the forefront. The first is that we have tacitly accepted that growth will now be more important than inflation and that the monetary policy in particular will be geared in this direction. This in turn makes the overall approach to policy fairly fickle, as the three reductions were in a span of just a little over a week. This phased reduction has now sort of matched the deficit that has come up in the system. The fact that we are now going to focus on growth means that inflation is not a worry. But, what if inflation starts rising again? This will become a delicate issue because by lowering rates at this time to spur growth, higher demand, especially from investment, could lead to the problem of lags and leads, which can be painful in terms of higher inflation in the interim period. What would be the approach then? We may have to restart increasing the CRR and repo rates again.
The second issue is that theoretically we need to be more sure of the use of the monetary policy. The Rational Expectations Theory propounded by Lucas and Sergeant would advocate strict targeting of money supply and rates by the monetary authority and silence there onwards. The markets are smart enough and efficient to take the cue and make the required adjustments. However, this year, probably on account of certain compulsions, the CRR was increased when inflation was high. And now that we are used to a high inflation number, the rates are being lowered to spur growth. The market gets confused signals about the monetary stance, which paradoxically provides scope for the monetary policy to be effective.
This kind of excessive fine tuning, though theoretically sound, does send mixed signals and a statement from RBI regarding its focus would actually guide the markets, as the present measures may only provide solace of affirmative action being taken. We have already lost out on growth by raising the rates and run the risk of having the double-digit inflation rate follow us till March. Industrial growth could get sliced down by 2% points, as banks have decided not to reduce rates as yet. Maybe they are waiting for the repo rate cut now. We are now banking on the kharif harvest and falling oil prices; as also the declining metal prices, following lower demand on account of the global slowdown, to provide comfort on the inflation numbers. However, we may still have to fall back on the supply factors for relief in inflation, as the present relaxation in CRR has the potential to stoke demand side factors. The rest of the year is surely going to be a challenging one.