A policy rate catch-22

The RBI is trying to control inflation by keeping interest rates high rather than encourage economic growth by cutting interest rates

That’s some catch, that Catch-22,” says Yossarian, the lead character in Joseph Heller’s all-time classic, Catch-22. Duvvuri Subbarao, the governor of the Reserve Bank of India (RBI), is facing a catch-22 situation at present and some catch it is.

He needs to decide whether to encourage economic growth or to control inflation. Theoretically, Mr Subbarao can encourage economic growth by cutting the interest rates. But that is likely to fuel inflation as people and companies will borrow and spend more, leading to a rise in prices.
He can control inflation by keeping the interest rates high. But that will kill economic growth as businesses don’t borrow money to expand and people will go slow on taking loans for purchasing cars, motorcycles, homes and consumer durables. This will hurt businesses and slow down economic growth.
The RBI seems to be trying to control inflation by keeping interest rates high rather than try and encourage economic growth by cutting interest rates. In the first quarter review of monetary policy, 2012-2013, which was released on July 31, 2012, the RBI decided to keep the repo rate at eight per cent. Repo rate is the interest rate at which the RBI lends to banks.
By keeping the repo rate high the RBI hopes to control inflation. “The primary focus of the monetary policy remains inflation control,” the RBI said in a statement on Tuesday. But economic theory and practice don’t always go together.
Inflation in India is primarily on account of rising oil prices and food prices. Oil is a commodity that is bought and sold internationally and the RBI cannot control its price. The price of oil had been falling since the beginning of this year but it has started to inch its way up and as I write this, brent crude oil is being quoted at $105 per barrel. While the government has shielded the people from a rise in oil price by not raising the prices of diesel, LPG and kerosene, petrol prices have been raised.
As far as food is concerned, there seems to be a structural shift happening. “The stickiness in inflation… was largely on account of high primary food inflation… due to an unusual spike in vegetable prices and sustained high inflation in protein items,” the RBI said.
Protein items primarily include various kinds of pulses, milk and other dairy items. Various social schemes being run by the current UPA government have put more money into the hands of rural India. One thing that seems to have happened because of this is that people are eating better than before.
Economic theory suggests that once income levels rise above $1,000 per annum, a major portion of the increased income is spent on more food and better-quality food. Also people shift from cereal-based diets to protein-based diets. In large parts of the world this means an increase in the consumption of meat. But in India it means more consumption of milk and pulses. Again, this is something that the RBI has no control over. As long as the UPA keeps running its social schemes this phenomenon of increased food prices is likely to continue.
What does not help in the near term is a deficient monsoon. Rainfall until July 25, 2012, has been 22 per cent below its long-period average. This means food prices will continue to rise. What this clearly tells us is that the RBI is not in a position to control inflation as it stands today. So should it be cutting the repo rate and, in the process, encourage economic growth?
When the RBI cuts the repo rate it is essentially giving a signal to banks that it expects the interest rates to go down in the days to come. But it is up to the banks to decide whether they take that signal seriously. When the RBI cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage point) in April, the banks cut their interest rates by only 25 basis points on an
average.
The reason was the increased borrowing by the government to finance its growing fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends. Between 2007 and 2012, the fiscal deficit of the government has gone up by more than 300 per cent. In the same period its income has increased by just 36 per cent.
Fiscal deficit has been growing on account of various subsidies like oil, food and fertiliser being offered by the government. “During April-May 2012, while food subsidies were lower, fertiliser subsidies were more than twice the previous year’s level,” the RBI statement pointed out.
What also does not help is the fact that the Rs 43,580 crore oil subsidy budgeted for this year has already run out. The government compensates the oil marketing companies (OMCs) for selling kerosene, diesel and LPG below cost. With international oil prices over $100 per barrel again, the oil subsidies are likely to increase in the days to come.
This means increased borrowing by the government to compensate the OMCs for their losses. Increased borrowing by the government will mean that banks will have a lower pool of money to borrow from and hence, they will have to continue to offer high interest rates on their deposits and charge high interest rates on their loans.
So what is the way out? “Clearly, if the target of restricting the expenditure on subsidies to under two per cent of the GDP in 2012-13, as set out in the Union Budget, is to be achieved, immediate action on fuel and fertiliser subsidies will be required,” the RBI said.
But raising prices is easier said than done. Another theory being bandied around is that Mr Subbarao is Union home minister P. Chidambaram’s man and he will start cutting the repo rate as soon as Mr Chidambaram is back at the finance ministry.

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