RELATIONS between the central government and the Reserve Bank of India have been uneasy over the past few months, especially over the question of easing of the tight monetary policy.

India’s central bank, under Raghuram Rajan, the present governor, steadfastly refused to lower interest rates last year despite pressures from the finance ministry. Industry lobbies have been critical of the RBI’s move to pursue a policy of high interest rates, especially when the inflation appeared to be well under control.

But Rajan, who was chief economist of the International Monetary Fund, is one of those fiercely independent governors, who brooks no interference from the government in formulating monetary policy. However, in 2015 Rajan appears to have softened his stand. Earlier this month, just days after finance minister Arun Jaitley presented his budget, Rajan surprised the markets by announcing an unscheduled cut in interest rates.

The RBI reduced the repo rate (the rate at which banks borrow funds from the central bank) by 25 basis points, bringing it down to 7.5pc. With slightly cheaper funds, banks are expected to pass on some benefits to consumers, especially those who have taken home loans.

Rajan’s move comes less than two months after he initiated a similar rate-cut, reducing the repo rate by 25 basis points. In both instances, the governor opted to reduce the rates outside the “Softer readings on inflation are expected to come in through the first half of 2015-16 before firming up to below 6pc in the second half,” declared Rajan. “The fiscal consolidation programme, while delayed, may compensate in quality, especially if state governments are co-operative. Given low capacity utilisation and still weak indicators of production and credit off-take, it is appropriate for the Reserve Bank to be pre-emptive in its policy action to utilise available space for monetary accommo­dation.”

The RBI’s action came much before the April bi-monthly meeting, just as its earlier rate-cut was also announced outside of the policy cycle. Basically, three factors appear to have prompted the central bank to take the decision: the latest data for inflation (for February) indicated that at 5.1pc it was well within the RBI’s target; the finance minister in his budget promised to improve the quality of fiscal adjustment; and the signing of the agreement between the government and the RBI of a new monetary policy framework.

The decision to target inflation is a landmark move in India. The government and the RBI have set a consumer inflation target of 4pc, with a band of plus or minus 2pc, for fiscal 2016-17

Analysts now widely expect the RBI to cut the rates further by about 50 basis points, considering the fact that inflation is expected to be much below the central bank’s target of 6pc for fiscal 2015-16. Of course, the RBI has set an even tougher target of 4pc inflation for the following year, which would be a difficult task to achieve.

In the budget, finance minister Jaitley opted for an across-the-board hike in service tax from 12.36pc to 14pc. Similarly, the railway minister had two days earlier raised rail freight on several commodities, which would have an impact on inflation. The RBI’s move was widely welcomed by the government. The government’s chief economic advisor, Arvind Subramanian was hopeful that international ratings agencies would now consider upgrading their stance on India’s credit outlook. “Now we have a 50 basis points rate cut (in two tranches within two months) and I think that is good for the economy,” he said. “The outlook is looking good the rating agencies should draw their lessons from that and improve the outlook.”

After Jaitley presented his budget, global ratings agencies were unhappy with his move to relax fiscal consolidation by delaying the fiscal deficit target by a year.

THE government has also warned banks that it would not tolerate if they refused to pass the benefits of the rate cut to their consumers. Junior minister for finance Jayant Sinha warned the government would initiate steps against banks which indulge in anti-competitive moves like not passing on the benefit to consumers.

Most public sector banks have not passed on the benefits of lower interest rates to consumers, sparking criticism. According to banking industry sources, lenders might start reducing interest on borrowings only from the new fiscal beginning April 1. Many banks though had reduced the deposit rates after the earlier rate cut.

Rajan’s rate cut also came immediately after the RBI signed a new monetary policy framework under which the central bank will focus mainly on monetary policy and setting interest rates. The new framework would commit the RBI to ensure that inflation remains below 6pc. A committee headed by a retired judge had suggested a formal framework with a panel headed by the RBI governor wielding a veto to set interest rates.

The decision to target inflation is a landmark move in India. The government and the RBI have set a consumer inflation target of 4pc, with a band of plus or minus 2pc for fiscal 2016-17. If the RBI fails in its task and if inflation remains at above 6pc or below 2pc for three consecutive quarters beginning the new fiscal, the governor will have to give a report to the government on why it failed to do so.

According to Jaitley, the framework was signed to institutionalise the battle over inflation. Such agreements between a central bank and the government are not uncommon in the developed world, but India has opted for such a clear-cut agreement with the RBI for the first time.

Originally, it was planned to have a five-member monetary policy committee, but that recommendation has not been implemented and all the powers are now vested with the RBI governor. There are also differences between the government and the RBI on the presence of outside experts in the committee.

Successive governments in India have had differences with the RBI on battling price rise. While governments formulate populist policies — such as providing free electricity, water, etc to voters — they are not ready to deal with the consequences, which include a high price regime. But now that there are clear-cut and defined roles, the RBI can pull up the government in case inflation refuses to be tamed.

Published in Dawn, Economic & Business March 16th , 2015

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