In probably his last monetary policy review before he retires, RBI governor Dr Reddy increased the repo rate yet again, after hiking the rate twice last month, in a move perceived as "very aggressive". Is the RBI pre-empting the possible increase in government spending ahead of general elections? By Shivshanker Verma

Even as Dr Reddy and his team at RBI were finalising the quarterly policy review, there were some mildly positive developments on the inflation front. International oil prices have corrected appreciably in recent weeks while monsoon rains have gathered strength and raised hopes of higher farm output this year as well.

While lower oil prices would help the government hold retail fuel prices, if not reduce them, sustained growth in the farm sector should bring down food price inflation in the coming months. Higher than expected agriculture growth had nudged last year's GDP growth slightly above 9 per cent and should help overall growth this financial year too.

These positive factors encouraged some economists and commentators, including former RBI governor S Venkitaramanan, to speculate about the possibility of RBI opting for a modest rate hike or even holding the rates steady. After all Dr Reddy had hiked the repo rate twice last month by a total of 75 basis points and the cash reserve ratio by 25 basis points.

There are clear signs of the economy responding to earlier rounds of monetary tightening, as the most recent industrial growth rate was the weakest in six years. Asset prices have come off appreciably this year, and may decline further in coming months. Dr Reddy maintaining status quo on interest rates seemed probable.

But, Dr Reddy delivered a double whammy yesterday by hiking the repo rate by 50 basis points and the cash reserve ratio by another 25 basis points. Most analysts and market participants were taken by surprise and the stock market tanked. Newspaper editorials have termed the RBI move as overkill, excessive and an overreaction – none seem to be supportive of the extent of the hike though most agree with the need for policy tightening. Market sentiment, which received a big boost after the government's trust-vote win on hopes of renewed reform vigour, has turned weak again.

Growth concerns
When newspaper articles start talking about how consumers are readjusting their spending patterns to cope with modest increases in salaries and bonuses, and higher costs of every item they consume, we know that the economy is in for some trouble. That was the biggest argument in favour of a mild rate hike, or a pause. Economic growth needs a bit of 'nurturing' at this point as every sector in the economy is facing a slowdown, even if it has come after four years of steady and sustained expansion.

While the impact of a slowing global economy is visible only in select sectors, most are affected by weak domestic demand growth. Higher interest rates have affected discretionary spending, most visible in subdued demand for durables.

The steadily weakening global growth outlook is not helping matters the outlook for the Indain economy, either. Most recent forecasts expect the US economy to contract later this year, and probably the first half of next year too. Growth outlook for other major economies – Europe, Japan and China – have also weakened as interest rates have been hiked everywhere to fight inflation.

The bigger worry is that past monetary tightening might prove insufficient and rates will have to go up further.

To add to the gloom, some predict the credit crisis to worsen in coming months. Major global banks continue to write-off billions of dollars and seek additional capital to survive. Consumer debt defaults are rising and most analysts expect corporate bond defaults, surprisingly tame so far in this credit crisis, to increase as well. In its most recent outlook, the IMF says the housing market in the US and Europe will take more time to bottom out. The institution has maintained its earlier forecast of $1 trillion in total losses from the credit crisis. The scary part is that we have not yet reached the half-way mark of that forecast!

The RBI is worried about growth and acknowledges that the outlook is not all that rosy. It has lowered the GDP growth forecast for the current financial year to 8 per cent, from 8.5 per cent earlier. That is still higher than the estimates by most private sector forecasters, but a clear acknowledgement that 'official optimism' in the economy is waning. Private forecasters have even started lowering their estimates for the next financial year, ending March 2010, like Goldman Sachs which now expects GDP growth to slip to 7.2 per cent that year.

Nevertheless, the RBI has preferred to ignore economic growth concerns for now. And the central bank has clear reasons for doing so.

Inflation may not have peaked yet
Most commentators who called for a mild rate hike or a pause expect inflation to decline in the coming months. The biggest positive as far as they are concerned is the correction in international oil prices. There is clear evidence of demand destruction because of high energy prices and the market is now adjusting to that. But, for prices to decline further or even remain at the current levels, geopolitical factors have to remain favourable. Any worsening of such factors, like the stand-off with Iran over nuclear reactors and the threat of military action against Iran by Israel, can push up oil prices.

Even if oil prices remain at this level, or correct some more, it will not bring much relief as far as domestic inflation in India is concerned. The simple reason is that oil price should slip well below $100 per barrel for the domestic oil retailers to break even at current pump prices. When that is that case, all the crude oil price correction does is to reduce the possibility of further hikes in retail fuel prices.

It is indeed possible that farm output this year will be as good as forecasts and food prices will ease after the next harvest. But, despite the assurances of the meteorological department, the monsoon doesn't quite appear normal this year. If cereal output falls short of current estimates, food prices will remain elevated and push up inflation even higher in coming months.

When wholesale price inflation is at its highest level in more than a decade, at close to 12 per cent, it is difficult to accept that prices can go up further. But, some forecasters now believe wholesale price inflation can rise to 15 per cent by the end of this calendar year. The RBI has also shed its confidence about containing inflation to between 5 and 5.5 per cent and now says its efforts will be to limit it to a 'more realistic target' of 7 per cent by the end of this financial year. And Dr. Reddy knows it will be a tough ask for his successor to meet that target.

Does the RBI fear a worsening fiscal deficit?
Dr. Reddy's aggressive rate hike is clearly a pre-emptive move, hawkish than most expectations and intended to deliver a definitive signal. So, the question is, what is the RBI fearing the most at this point? Yes, inflation can worsen. But, that doesn't quite support such an aggressive monetary policy move.

The only factor that may explain the RBI's cautiousness is the possibility of a further worsening in the government's fiscal deficit. As against a target of 2.5 per cent of GDP, the fiscal deficit has already worsened to 6.5 per cent if we include the higher oil and fertiliser subsidies, which the government has conveniently kept as 'off-balance sheet items' and not accounted for in current year budget. Expansion of the fiscal deficit means the government is spending more, which defeats the purpose of tighter monetary policy by sustaining demand growth. But, higher government spending can deliver short term political gains.

Given the political compulsions ahead of a general election, it is quite possible that the government will step up spending during its remaining term. The political realignments in recent weeks, and the deals and commitments that usually go with them, have made this possibility even more real. Given the tight spot the ruling alliance is in, after losses in elections to many state assemblies, it will be hardly surprising if they decide to try and spend their way out of troubles.

In any case, the pay commission recommendation of higher salaries to government employees will be implemented before the elections. If inflation doesn't subside by the end of this calendar year, expect more subsidies and a fuel price cut even if international oil prices remain high. The aam admi doesn't care if the GDP growth is 8 per cent or 7 per cent, but they will be angry if prices continue to rise.

Dr Reddy is well aware of these possibilities. The seasoned bureaucrat that he is, he knows that inflation is a far bigger concern for the government than economic growth rate in an election year. And probably that is what the governor meant when he stated categorically that the central bank and the finance ministry are 'always in sync'.

The economy will undoubtedly pay a price in terms of lower growth rates, more so during the next financial year. But that is the price for fiscal profligacy, for populist excesses despite the innovative methods to defer their cost. Don't blame the RBI for that.