Should RBI be a hawk or a dove?

Thu, 15 Nov Pre-Open

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The Reserve Bank of India (RBI) has come under pressure from the Finance Ministry. The reason has been the former's hawkish stance. The Finance Minister had painted a rosy picture for reducing the fiscal deficit. The key aim was to induce the RBI to reduce interest rates. However, the RBI Governor withstood all pressure and stuck to his guns. He did not reduce the benchmark interest rates. Though he was criticized by the government, his reasons were strong. Till inflation came under control, reducing interest rates was definitely not an option. The result was a divided India. One set believes that the RBI is correct in continuing with its hawkish stance. The other believes that the latter's conservative attitude is hurting India's growth prospects.

In such times two figures were released earlier this week. The first was the figure for the country's Index for Industrial Production or the IIP. The IIP has contracted by 0.4% during the month of September 2012. This was versus a 2.5% growth in September last year. This abysmal number suggests that the country's industrial growth is indeed suffering. This necessitates a cut in the benchmark rates to boost investments and therefore the industrial production.

On the other hand the figures released for retail inflation seem to be pointing at the other end. The Consumer Price Index (CPI) has increased to 9.75% in October 2012 as compared to 9.73% in September 2012. If one looks at this number then the RBI's stand seems to be justified.

So there we have it. The industry is languishing which justifies the need for lower interest rates. At the same time inflation is still high which justifies interest rates remaining at the levels they are. As a result the big question is what should the RBI do? Should it swallow the pill and cut down the rates to support the industry? But this would mean that liquidity in the system would shoot up. Thereby stoking asset prices and hence inflation further upwards. But if it continues with its existing stand, industrial growth would continue to languish.

This puts the RBI is in a precarious position. It needs to find a middle path to support the economy and balance the inflation. Or maybe the government could step in here and help the RBI out instead. All it needs to do is to speed up policy reforms. That would help boost the industry as well as the economy.