Holding firm: Subbarao refuses to buy feel-good factor

Reserve Bank of India (RBI) Governor Duvvuri Subbarao did not surprise on the upside. Despite the frenetic action from New Delhi last week on diesel prices, disinvestment and foreign direct investment (FDI) in critical areas like retail and aviation, the RBI has decided not to soften its stance just yet on the repo rate.

At its mid-quarter policy review today, the RBI kept the repo rate - the rate at which the central bank lends short-term funds to the banking system - unchanged at 8 percent. However, there was an important signal the RBI did send - it cut the cash reserve ratio, the portion of deposits banks keep with the central bank, by 25 basis points, indicating that it was keen to allow more money to come into the system. The CRR cut alone will release Rs 17,000 crore into the banking system.

But by keeping the key rates unchanged, the RBI has signalled two things: one, despite last week's actions by the government, taken despite political opposition, the central bank perhaps wants to wait a little longer and examine how far the government will go on reform before it takes a longer term call on rates.

While the government has started to do its bit in spurring growth, the RBI still has very little headroom since inflation pressures persist. Reuters

Second, the decision not to reduce the repo rate also makes it amply clear that the central bank's primary job is to control inflationary expectations and, on that front, the RBI is far away from its comfort zone.

Inflation came in at 7.55 percent last week, far above the comfort zone of the RBI of 5 percent, with core inflation too remaining sticky. The chairman of the Prime Minister's Economic Advisory Committee, C Rangarajan, in fact, underscored the central bank's viewpoint when he told CNBC-TV18 after the RBI announcement that the key role of a central bank would be to control inflation. Subbarao has once again signalled his preference for inflation in the growth-inflation balance.

However, it's not as if the recent measures from the government's side have gone unnoticed at Mint Road. Says RBI in its policy review: "Mitigating the growth risks and taking the economy to a higher sustainable growth trajectory requires concerted policy action across a range of domains, a process to which last week's actions made a significant contribution. Monetary policy also has an important role in supporting the growth revival. However, in the current situation, persistent inflationary pressures alongside risks emerging from twin deficits - current account deficit and fiscal deficit - constrain a stronger response of monetary policy to growth risks."

In other words, while the government has started to do its bit in spurring growth, the RBI still has very little headroom since inflation pressures persist. Accordingly, as this process evolves, the stance of monetary policy will be conditioned by careful and continuous monitoring of the evolving growth-inflation dynamic, management of liquidity conditions to ensure adequate flows of credit to productive sectors and appropriate responses to shocks emanating from external developments, RBI says.

For now, industry will surely be disappointed, since the 'feel-good' factor of last week's policy measures from New Delhi had led to expectations of a rate cut from Subbarao's side. But, as pointed out by State Bank of India Chairman Pratip Chaudhuri, a CRR cut can be an effective tool in making more money available to the banking system, allowing the flow of credit to productive sectors. Coming on the back of a one percentage point cut in the statutory liquidity ratio (SLR) the last time the RBI met to review its policy, this measure will ease the flow of credit somewhat.

By not falling prey to the immediate feel-good pressures, the RBI has displayed the kind of maturity expected of a monetary authority. An inflation rate of 7.55 percent - no matter what the other conditions - cannot warrant a rate cut. For the central bank, the war against inflation is far from over. The bosses of India Inc would do well to realise that.