Hard money: It's less Subbarao vs FM, more PMO vs Sonia

What’s really going on in monetary policy? Who is calling the shots, and why? Why is the Reserve Bank of India (RBI) still hawkish when the economy is dramatically slowing down and industrial growth has just crashed to negative territory in October?

The RBI's decision to stick to its hard monetary stance - no change in tight money or rates barring some lip-service to slowing growth - has angered some economists who think the central bank is either being unduly influenced by hard-boiled monetarists or is acting like a law unto itself.

Surjit Bhalla, chairman of Oxus Investments, is one bitter critic of the central bank’s lack of accountability, and suggests that “the RBI stands out alone in the entire world with its ultra-hawkish policy against inflation.” Bhalla wants the RBI to present its diagnosis and policy prescriptions to parliament twice a year - just like the US Fed does - to ensure better accountability.

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Bhalla’s Exhibit A to prove that the RBI is a law unto itself is this: while the governor’s Technical Advisory Committee (TAC) had recommended a 45 basis points (100 basis points make 1 percent) hike in repo rates this year, the RBI gave us five times as much - 225 basis points. Firstpost has reported earlier on how RBI Governor D Subbarao has been almost the lone hawk in TAC.

Where did Subbarao find the courage to overrule his own internal advisors and his political bosses in government? Especially, when his own extension was up in the air last September?

Writing in The Indian Express, Bhalla raises the possibility that Subbarao’s hawkishness may have been influenced by the Manmohan Singh-C Rangarajan duo - both former governors of the RBI themselves. During the first half of the 1990s, when Manmohan Singh as Narasimha Rao’s finance minister started loosening up on spending under political pressure - precisely the current situation in UPA-2 - Rangarajan as RBI governor then started pushing up rates steadily.

Says Bhalla: “Let me state that there are sufficient rumours about the possibility that the RBI is being dictated to by the Delhi combine of Manmohan Singh and his chief (and it appears, only) economic adviser, C Rangarajan. If this is the case, then substitute lack of coherence of RBI’s actions to lack of coherence of Manmohan Singh-C Rangarajan’s actions.”

The argument against using monetary policy to deal with food inflation - which was the problem till recently - is simple. Food prices and demand are not driven by the cost of money, but by supply side issues like agricultural productivity and availability. So using higher rates to subdue food inflation is foolish. It does more damage to growth than inflation.

The RBI’s counterargument is that when inflationary expectations are taking hold, food inflation can feed into other prices. Hence it is important to break the back of inflationary expectations.

But tough stands have consequences.

The Manmohan Singh-Rangarajan rate hikes of the 1990s brought down the economy’s growth rates (and inflation) in the second half of the 1990s. It took almost a decade for the economy (in 2003-04) to recover its 7 percent growth momentum.

Are we getting into the same situation now?

If we were to see monetary policy as being a response to what’s happening in the political economy, then the tensions between fiscal and monetary policy can be more easily explained.

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At the core of fiscal profligacy is the huge social sector spending plans of Sonia Gandhi and her National Advisory Council. The fisc is slipping because spending is being influenced purely by Sonia Gandhi’s political calculations (hence the huge increase in oil and fertiliser subsidy bills, and the potentially ruinous Food Security Bill).

It would not be wrong to say, therefore, that fiscal policy is being driven by politics - Sonia Gandhi’s politics - and monetary policy is a counter to that.

Fiscal looseness emasculates the government of Manmohan Singh, which now retains only monetary policy directly under its control. It is not difficult to see why he is using the blunt instrument of monetary policy (through Subbarao) to send Sonia Gandhi a message that fiscal overspending has huge growth consequences.

In fact, Subbarao’s monetary policy assessments always have a huge message on failing fiscal policy. In the latest one announced on Friday, the RBI noted pointedly: “The central government’s key deficit indicators worsened during 2011-12 (April-October), primarily on account of a decline in revenue receipts and increase in expenditure, particularly subsidies. …The likely slippage in this year’s fiscal deficit has inflationary implications.”

The RBI also stressed that inflation is far from being controlled. “Both inflation and inflation expectations are currently above the comfort level of the Reserve Bank.”

Thus, even while noting the industrial slowdown and the softening in prices, the RBI is essentially flagging the central government’s fiscal expansion as the real threat on inflation.

The finance ministry, which has to foot Sonia Gandhi’s subsidy bills by borrowing from the market, has been worried sick about rising interest rates. The ministry’s chief economic advisor, Kaushik Basu, has called for “out-of-the-box” thinking on rates - because higher rates damage the budget’s arithmetic even more.

So what at first seemed like Subbarao versus the finance ministry now looks like PMO versus Sonia Gandhi.

It’s quite obvious that neither Manmohan Singh nor Pranab Mukherjee is very happy about the politics-induced pressure to abandon fiscal prudence - or what little there is of it. The Food Security Bill will, of course, put paid to any remaining thoughts on keeping the fiscal deficit within reasonable limits. As the RBI ruefully noted: “The fiscal deficit, at 74.4 percent of the budgeted estimate in the first seven months of 2011-12, was significantly higher than 42.6 per cent in the corresponding period last year.”

But the deficit can only get worse. According to BusinessLine, the Commission on Agricultural Costs and Prices (CACP) calculates that the real cost of the Food Bill, currently estimated in the range of Rs 1,00,000-1,50,000 crore, may rise to Rs 2,00,000 crore - at which point, all bets are off on inflation.

Given the scale of the slippage, and given Sonia Gandhi’s ill-disguised unhappiness with the government’s foot-dragging on the Food Security Bill, it is obvious that Manmohan Singh and Rangarajan are trying to warn her of the dangers of her fiscal recklessness by stamping hard on the monetary brake.

The real answer to inflation lies in ending the policy paralysis, and improving the supply situation in agriculture and industry, and investing in infrastructure. But a bankrupt government can do none of that.

The world knows this - and this is the prime reason why the rupee is also slipping.

For a mental picture of the UPA’s economics, think of Sonia, Subbarao and Manmohan driving a car with Sonia’s foot on the accelerator, Manmohan’s on the clutch, and Subbarao’s on the brake.

No car can survive this kind of driving.