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The Big Picture – GDP numbers & Monetary Policy

The Big Picture – GDP numbers & Monetary Policy


The Reserve Bank of India (RBI) has kept its key repo lending rate unchanged at 6.75%. This move was widely expected. The consumer inflation has also picked up to a four-month high. RBI Governor Raghuram Rajan has left open the door for more easing, noting weak rural and global demand was holding back economic growth, while highlighting pockets of weakness in sectors such as construction. RBI is keeping a lot of hope that the government will manage the fiscal deficit even after implementing the pay commission’s recommendations.

At the margin, food prices and pay commission may have some impact but the government has found enough compensatory areas to save and lower the fiscal deficit. But, the combination of the current government and RBI policies will ensure that markets remain in good shape. The further rate cuts are dependent on the path of fiscal consolidation. Through four rate cuts, the latest being a 50-basis-point (bp) one on September 29, RBI has brought down the repo rate to 6.75% from eight per cent in January.

Despite aggressive rate cuts by the central bank, commercial banks have not really passed on the rates to customers, inviting sharp criticism from the RBI governor. RBI governor had said that the central bank’s stance would continue to be accommodative but the focus of monetary action for the near term would shift to working with the government to ensure that impediments to banks passing on the bulk of the cumulative 125-bps cut in the policy rate are removed.

The central government has said it will contain its fiscal deficit to 3.9% of gross domestic product (GDP) in 2015-16, and progressively bring it down to 3.5% and 3% in the next two years. Recently released data show that government has managed to remain on track, as the deficit reached 74% of the full-year target during April-October, against 89.6% in the corresponding period last year. However, the recommendations by the Seventh Pay Commission, if accepted, might put pressure on the numbers as the planned pay hike to government employees equals 0.68% of GDP. State governments are also likely to strain their finances while giving good hikes to their employees. This might upset the overall deficit figures and would be inflationary.

The US Federal Reserve is also expected to raise interest rates in December, for the first time since June 2006. Already, foreign portfolio investors are liquidating their holdings from emerging markets and the impact has been felt in India as well. The value of rupee is also falling. Hence, RBI has intervened in the market to strengthen the rupee and such intervention could become a regular feature in the coming months. This would strain the central bank’s foreign exchange reserves and all the dollar purchases would infuse an equivalent amount of rupee liquidity in the market which, again, would be inflationary.

However, much also depends on how China tackles its domestic slowdown. In the past, China had readjusted its currency band and that led to all Asian currencies falling sharply to maintain export competitiveness. In response to the yuan’s 2% devaluation, the rupee depreciated three per cent. Any move to fight this depreciation will not only hurt India’s exports, but also add more to the depreciation and will upset RBI’s inflation targeting mandate.

The economic recovery is far from convincing and a lot of government action is required to consolidate the positive signals in different sectors. It is imperative that the Centre co-ordinates with states to alleviate agrarian distress. Retail inflation, driven by food inflation, has been close to 5%, despite wholesale inflation being in negative territory. The management of the food economy is crucial. Now, it is incumbent on government investment, especially in infrastructure, to create a climate that encourages growth.