Business Today

'Monetary policy wasn't loose'

Puja Mehra | Print Edition: May 29, 2011

He received enormous praise for the Reserve Bank's deft handling of the macro economy in the face of the financial meltdown triggered by the collapse of Wall Street firm Lehman Brothers and the eventual global economic downturn of 2008/09. But RBI Governor Duvvuri Subbarao is now being blamed for India's inflation problem. In an interview with Associate Editor Puja Mehra soon after announcing the annual monetary policy on May 3, Subbarao rebutted his critics and said that, looking back, he would not have done anything differently. Edited excerpts:

Q. The Reserve Bank drastically revised its projections for inflation and yet the actual numbers came out a percentage point higher in March than the RBI's eight per cent projection. Why could the RBI not project inflation accurately?
The actual numbers for inflation started deviating from our projections December 2010 onwards. In the period from April to December 2010 our forecasts were pretty much on track. A lot of known unknowns have come into play. For one, the [rise in] international crude prices was a result of a number of supply and demand factors which could not have been foreseen. That there would be such recovery in advanced economies, that there would be financialisation of commodities, and the political developments in Africa and Middle East [were all unexpected]. Second, input price rises translated into higher output prices because of demand pressures that were much stronger than we had thought.

RBI Governor Duvvuri Subbarao
The fiscal deficit can affect the aggregate demand. So we have said that it is a variable that affects demand and so inflation management
Third, there was the unseasonal rise in vegetable prices. What the economists in RBI told me is that the non-food manufacturing inflation numbers for December 2010 to February 2011 had under-reflected the demand pressures. Therefore, we went off-track in getting the March numbers. That is not to say we need not improve our forecasting techniques.

Q. Business Today has constructed a Business Confidence Index whose first survey ended in early March. Our main finding was that companies are enjoying significant pricing power owing to robust demand, just as the annual monetary policy statement notes. Business, it would seem, loves inflation....
They might have loved inflation as input prices were high and without sacrificing their margins they were able to pass on input price rises, but that was clearly unsustainable. They could not maintain that for long. It was not in the interest of long term profitability.

Q. Because it comes back to haunt them as wage cost inflation pressures?
That's right.

Q. So were demand pressures high as monetary and fiscal policies were loose for longer than desirable?
Monetary policy wasn't loose. If you look at M3 [a measure for money in circulation in an economy which, if high, can fuel inflation, as too much money chases a supply of goods and services that cannot be expanded in the immediate term] it was 15.9 per cent - certainly below our projection of 17 per cent. If you look at real policy rates, which is another indicator analysts throw at me, depending on what inflation rate you use for expected inflation, you could arrive at positive or negative real rates. But the important thing to remember is where we are coming from. We had done extraordinary loosening during the crisis. Policy rates fell to historically low levels. We needed time to bring them up and it needed to be done in baby steps. So to say monetary policy was loose beyond the appropriate time would be incorrect. You might recall that many analysts were saying that we should have loosened further. The same people now say it was much too loose for far too long.

Q. Would you say then that demand pressures were high because of the fiscal policy?
I don't want to comment on that but the fiscal stimulus that the government had given as an anti-crisis management measure was called for. Reversing that and reverting to our track of fiscal consolidation is also an important imperative. The government has done that, although there is some talk that the projections are short of the targets indicated by the Thirteenth Finance Commission.

RBI Governor Duvvuri Subbarao
The endeavour for the Reserve Bank is to bring inflation down to create a more conducive environment for investments
It is difficult both politically and macro-economically to bring the fiscal deficit down but it needs to be done. I won't call the fiscal policy excessive or accomodative but I would certainly say that fiscal consolidation is an important imperative for our inflation management.
Q. Are you throwing the ball into the government's court as far as fighting inflation goes?
We are just stating a fact - that the government is a big player in the macro economy. The fiscal deficit can affect the aggregate demand. So we have said that it is a variable that affects demand and so inflation management.

Q. Will the government achieve the targets for fuel subsidies and, thereby, the fiscal deficit it set in Budget 2011?
The finance ministry had set targets in end-February. The oil situation was different then from what it is today. Certainly, there is doubt on whether those targets can be met unless adjustments are made to administered prices.

Q. The annual policy statement says that inflation is an evil, it hurts investments. Has the RBI finally said inflation targeting is its dharma?
I don't think you should translate our comment as an endorsement for inflation targeting because inflation targeting means something different. But it is quite true that when inflation is as high as this in a country as poor as ours, controlling it becomes the top priority. Indeed, even to have sustainable growth over the medium term we need low inflation so that we provide a predictable environment for investment.

Q. Industrialists are complaining that high interest rates, particularly the latest rate hike of 50 basis points, will hurt growth. Would you like to reassure them?
What I want to tell them is that inflation also hurts investors by creating uncertainty for them. The endeavour for the Reserve Bank is to bring inflation down to create a more conducive environment for investments so that even if we sacrifice some growth now, in the medium term we will have low inflation and high growth.

Q. What could you do differently for a better growth inflation combination than the 8.6 per cent you have projected?
Difficult to answer. We have no counterfactual [scenarios] to evaluate. Our policy action last year was driven by evolving an inflation growth scenario, as it is today. I am not sure that I would have done anything differently.

Full transcript of the interview at

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