Core Inflation And surging Imports Do Not Warrant Negative Interest Rates.

Does stalling industrial output and capital formation warrant a halt to the RBI's monetary tightening? Not as yet. Wednesday's inflation figures - 9.8% for all commodities and 7.8% for manufactured products - coupled with imports that surge even as export growth slows present a picture of untamed demand.

True, food inflation cannot be tackled by higher rates, except at exceptionally harsh levels. But when non-food, non-energy inflation runs so high, there is no case for negative real rates of interest. True, monetary policy works with lagged effects and inflation has started slowing on a sequential basis. This is a case for refraining from aggressive tightening, not for reversing the policy stance.

The steady depreciation of the rupee is another reason to abjure policy relaxation. The eroding rupee imports inflation via commodities, whose global prices are upwardly mobile thanks to easy money in most parts of the world. A stronger rupee would both dampen imports and commodity prices. To the extent monetary policy helps, firm rather than soft is what a stronger rupee calls for.

But, it could well be argued, India's growth prospects play a larger role in determining exchange rates through capital flows. But far more than monetary policy, it is the knock the overall credibility of the country's governance system has taken that is depressing sentiment and pushing capital out, depressing the rupee. A central bank that shows focus will only add to, and not detract from, credibility. It is up to the rest of the government to restore confidence by bringing decision-making and execution up to speed. Interest rates cannot make up for the slack in governance and consequential damage to the animal spirits that drive growth.

The RBI also needs to investigate if the rise in imports and exports has anything to do with attempts by domestic agents to take advantage of the extremely low rates of interest abroad, effecting the arbitrage through shortterm external trade finance. If it has, it has a bearing on how we read domestic demand and interest rates, and the RBI would need to act to protect the real economy from arbitrage-seeking financial flows.

Source : economictimes.indiatimes.com