RBI offering bitter but unavoidable medicine

Central bankers never talk about what the worst-case scenario is,' admitted Mervyn King, governor of the Bank of England , in a rare moment of candour. It's a different matter that King was referring to the Lord's test between India and England, where the worst-case scenario was that bad weather had set in and 'we are not going to get a single ball bowled for the rest of the day' . But he could well have been speaking for the governor of the Reserve Bank of India (RBI), D Subbarao. The Bank's First Quarter Review of Monetary Policy 2011-12 released last Tuesday paints a rather gloomy picture of slowing growth and persistent and high inflation but stops short of describing what the worst-case scenario could be, a return to the stagflation of the 1970s. After all, none of the factors advanced as justification for the sharper-than-expected hike in policy rates is particularly new or convincing. Demand pressures have been strong and inflation has been way higher than the RBI's own projections for the past many months. Yet the RBI preferred to hold its horses and persevere with 'baby-steps' . As for growth, it chose to ignore signs of over-heating when, arguably, there was a case for monetary tightening and tighten just when there are signs that growth has begun to moderate, even if, as the Statement says, there is 'no evidence as yet of a sharp of broad-based slowdown.' So why did the RBI turn much more hawkish than earlier ? Why did it decide that it is not only 'necessary to persevere with its anti-inflationary stance' , but also go on to administer harsher medicine than in the past, disregarding market expectations and its own decidedly more dovish past?  The Bank claims it has been among the most aggressive across the world in tightening liquidity (a debatable claim going by the accompanying table), but conveniently ignores the fact that even more aggression was called for since inflation is among the highest in India. So what changed? There are two possible explanations . One, the inflation outlook is far worse than the Bank has cared to admit to date. A careful reading of the RBI's First Quarter Review of Monetary Policy 2011-12 released last Tuesday suggests this might be so. For perhaps the first time, the RBI has put inflation concerns foremost and in no uncertain terms, calling it the 'dominant macroeconomic concern'. Better still, unlike the previous year when it retained its unrealistically low estimate for year-end inflation only to dent its credibility when the final March 2011 number came in, it has raised its inflation projection for March 2012. The Bank now expects fiscal 2011-12 to end with inflation at 7%, up from 6% projected in May this year. Even this comes with a number of caveats: the performance of the southwest monsoon that does not look too hopeful at present, crude oil prices whose outlook is uncertain , policy decisions regarding administered prices. Hence, we could end up with inflation well above 7%.

ET