Why Subbarao told the finmin to take a walk

By R Jagannathan

Finance Minister Pranab Mukherjee, who recently expressed the hope that he could walk on the lawns of Rashtrapati Bhawan even before Sonia Gandhi announced his candidature for president last week, has now got a coded message from the Reserve Bank Governor that, maybe, he should take a walk.

In fact, the message is that interest rates cannot fall unless there is a global catastrophe or the finance ministry delivers on its fiscal promises.

North Block and Mint Street have been on different planets when it comes to interest rate policy for quite some time now. The finance ministry’s chief economic advisor, Kaushik Basu, urged Duvvuri Subbarao to “ think out of the box” on interest rates as early as last June. It was advice which the governor ignored till last April, when he unexpectedly announced a 50 basis points cut in repo rates.

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A few days ago, just before the mid-quarter monetary policy review was to be unveiled on 18 June, the finance minister threw a not-so-subtle hint that the RBI might cut interest rates. Speaking at an Assocham meeting in Delhi, Mukherjee said: “I am confident that keeping in view all the factors, the RBI will adjust the monetary policy as we are adjusting the fiscal policy”.

Before that, Mukherjee even claimed that the shocking GDP slowdown in the fourth quarter of 2011-12 (when growth fell to 5.3 percent) was partly due to high interest rates.

On Monday, it was Subbarao’s turn to send a missile in the other direction. “Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small.”

Translated, this means, the slowdown is the result of the finance ministry’s many failures, not high rates.

Just in case North Block hasn’t got the message, Subbarao even seemed to suggest that he may have made a mistake by cutting rates in April when the finance ministry was still to deliver on fiscal consolidation. He said: “The Reserve Bank had frontloaded the policy rate reduction in April with a cut of 50 basis points. This decision was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives.”

Is Subbarao telling us that so far the RBI’s premise on “the process of fiscal consolidation” may have been misplaced?

His next sentence seems to confirm this assessment. “Consequently, further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures.”

This is a whisper in Mukherjee’s ear: “Since you didn’t deliver your part of the deal - fiscal consolidation - I have to cancel your rate-cut party for now.”

In fact, the RBI Governor seems to have toughened his stand on inflation by shifting the goalposts: he is now looking at the Consumer Price Index (CPI), which is above double-digits, and not Wholesale Prices (WPI).

He said: “Core inflation has moderated, reflecting demand conditions and lower pricing power. However, both headline and retail inflation rates are rising, which have a bearing on inflation expectations. Future actions will depend on a continuing assessment of external and domestic developments that contribute to lowering inflation risks.”

[caption id=“attachment_348004” align=“alignleft” width=“380” caption=“North Block and Mint Street have been on different planets when it comes to interest rate policy for quite some time now. Reuters”]  [/caption]

Says Rajeev Malik, Senior Economist at CLSA: “While WPI-core inflation has declined, the RBI appears to be giving more weight to high CPI inflation, which in turn also fashions household inflation expectations. CPI-new in May rose 10.4 percent year-on-year, similar to the downwardly revised 10.3 percent in April, but remained uncomfortably high. This is important as the RBI’s somewhat unilateral focus on WPI-core (i.e. manufacturing inflation) had inadvertently given rise to an incorrect view that only core inflation mattered.”

The Governor, it seems, is getting a lot more hawkish on inflation as Pranab Mukherjee looks set to bid goodbye to the finance ministry.

The Governor has listed four reasons for his abundant caution on rates. One, WPI is still rising, “driven mainly by food and fuel prices.” Two, “protein inflation continued to be in double digits.” Three, there is the rupee depreciation, which has “significantly offset” the impact of falling global oil prices. And four, “the absence of pass-through from international crude oil prices to domestic prices” is keeping consumption higher than necessary.

Little wonder, the Governor is happy to ignore Pranab-da.