Unlike central bank heads elsewhere, the Reserve Bank of India's governor is not elected. On May 3, the incumbent, Duvvuri Subbarao demonstrated the governor need not be popular either: in the annual monetary policy for 2011-12, the 62-year-old former Indian Administrative Services officer hiked interest rates for the ninth time since early 2010, this time by a bigger margin of 50 basis points, taking the repo rate - the rate at which it lends to banks - to 7.25 per cent. This rise in the cost of borrowings, the RBI acknowledges, will slow down the GDP growth rate for 2011/12 to eight per cent.
Predictably, Dalal Street booed the decision. The Sensex slid by 463 points on the day of the announcement. The Confederation of Indian Industry warned: "The rate hike will have an adverse impact on investments and growth." But did the RBI have a choice? It had hiked policy rates eight times since early 2010. And yet, despite a good monsoon and a record harvest, the inflation rate in March 2011, the latest month for which figures are available, was nine per cent. It was one per cent in early 2010.
A number of factors, many of which are beyond the RBI's control, are fuelling inflation. A significant one is demand, which Subbarao admitted in the policy statement was stronger than the RBI had imagined.
Strong demand has fuelled inflation because consumers are able to afford higher prices. So companies have passed on rising input costs without having to cut margins. Evidence of the strong consumption demand and significant pricing power showed up in the first BT C fore Business Confidence Index Survey
in early March too.
Demand will dampen if money becomes more expensive. So the RBI is fighting inflation with interest rate hikes or "monetary tightening". Through 2008 and 2009 it had dropped interest rates to stoke demand that had been hit by the global economic downturn. The "monetary loosening" supported GDP growth in the crisis. As did New Delhi's loose fiscal policy that slashed taxes and kept up public spending. The money consumers did not have to pay out in taxes, as also the money they could borrow cheap, they spent, boosting GDP growth.
The question, Subbarao's critics, especially those among them who would not like to see his tenure extended at the end of his three-year term this September, are asking is: did the Reserve bank delay the rollback of the monetary stimulus? Did it stoke demand too long and fuel inflation, as the supply side could not catch up?
In a post-policy interview to BT, Subbarao clarified that monetary policy was not to be blamed. After bringing down interest rates to historic lows in 2008/09, he could not have raised them overnight.
But did the UPA government dismantle its fiscal stimulus efficiently? For one, it did not decontrol retail prices of diesel, when the timing for it was apt and warnings aplenty. Rising crude prices have bloated its subsidy spending. The worsening fiscal deficit is feeding inflation while ill-targeted subsidies are preventing demand adjustments, a situation monetary policy cannot possibly fix. So the onus for tackling inflation now lies with Finance Minister Pranab Mukherjee. With elections in states over, will Mukherjee show the stomach for some unpopularity?