The central bank risks stagflation by loosening to stimulate growth
The Indian economy hit choppy waters this year and investors fear it is about to get worse. Prime Minister Manmohan Singh's government has abandoned reforms, most spectacularly on foreign investment in retail this month. Some reassurance came from the central bank, which steadied the economy this year by fighting double-digit inflation. But that bit of stability is threatened after the Reserve Bank of India signaled Friday that it's about to give up the fight, too. India faces the worst bout of inflation in major Asian economies, a dilemma the RBI earlier seemed to acknowledge. Prices have been rising at an annual clip of above 8% for nearly 24 months and it was encouraging to see RBI Governor Duvvuri Subbarao push up the short-term interest rate by 2.25 percentage points this year. Mr. Subbarao is now losing his nerve. On Friday, he refused to hike interest rates for the first time this year and strongly suggested he would loosen credit next year. That's incredible given that the policy rate is still negative in real terms and growth in the broad money supply is running higher than expected. Headline numbers did fall two months in a row, but prices still rose 9.1% year-on-year in November. The decline has much to do with base effects from the end of 2010. The central bank surely understands that Indians' inflation expectations have hardened after witnessing the most persistent rise in the prices of goods in the last two decades. These expectations are not going to be altered by two months' data, especially now that goods inflation has spread to wages—and, thanks to the economy's rigidities, become sticky. The real reason for the RBI's change of heart is the pleading of various interest groups to bring down the cost of credit. GDP growth slowed to 6.9% in the latest quarter, while industrial output last month has deteriorated. Easy money is an easy response to flagging growth, but it's the wrong prescription. Mr. Subbarao seems to think he can trade off inflation in favor of growth, but the last 30 years of experience with priming the monetary pump—or even the last three—should have taught him that there is no such correlation in the long run. The RBI is now recapitulating this experience. After it kept credit too cheap in 2008-09, India is now stuck with inflation and slowing growth. If Mr. Subbarao doubles down in coming months, he risks even more monetary instability this time around, probably without helping the cause of growth. He would also then fritter away the gains made by tightening in the past year. Meanwhile, as the RBI's credibility dissipates, the rupee is being hammered against the dollar. In desperation, Mr. Subbarao has dug into his toolkit, liberalizing foreign inflows into government bonds and some banking deposits, which is good though not sufficient at the moment. More worryingly, he's tried to curb speculation by imposing new rules last week on currency derivatives. What the central bank needs to restore stability to the rupee is a mandate for price stability, ideally achieved by targeting the exchange rate. Instead Mr. Subbarao juggles multiple mandates, including promoting growth. Except growth at this point is being held back more by regulation, than by the cost of credit. India's policy makers may not admit it, but they are stumbling into stagflation. The right way out of this mess is for Mr. Singh to drive growth through reforms and for Mr. Subbarao to maintain stable prices. It's bad enough that India's prime minister appears to have abdicated his responsibility, but its central banker will make things worse if he tries to compensate for Mr. Singh's failings.
WSJ
