Will RBI Governor D. Subbarao lock step with the government?

The tough task of marching together with the central government, which is struggling hard to put its fiscal house in order , will be weighing on Reserve Bank of India (RBI) Governor D. Subbarao as he prepares for the half-yearly monetary policy review on October 30, 2012.

There are high expectations all around.

The government, industry, as well as common man expect the 62-year-old Governor to cut the short term lending rate, or repo rate, from a high of 8 per cent to spur investment as well as growth. The repo rate was last tinkered with in April 2012, when the RBI reduced it by 50 points, which was more than expected.

In 2012, however, the RBI has used all the liquidity tools in its arsenal to infuse more funds into the system. Take, for instance, the cash reserve ratio (CRR), the share of deposits banks have to maintain with the RBI. The CRR was reduced from 5.5 per cent in January 2012 to 4.5 per cent in September this year.

In July, the statutory liquidity ratio (SLR), the proportion of deposits that have to be compulsorily invested in government securities, was lowered from 24 per cent to 23 per cent.

The RBI has also been injecting a huge amount of liquidity through open-market operations, buying bonds from banks.

But more than the liquidity, a repo-rate cut is something that is keenly awaited by all, as it directly signals a lowering of interest rates. Even if Subbarao cannot match step with the government in the manner his political masters want, the Governor is at least expected to cheer the sombre mood with a token 25-basis-point cut in the repo rate.

Will that be easy for a bureaucrat turned governor, who has been resisting an interest-rate cut over the last one-and-a-half years despite tremendous pressure from the government?

Inflation, which has been high for a long period , shows no sign of easing. Inflation, as measured by the wholesale price index (WPI), rose to 7.81 per cent in September as against 7.55 per cent in August. There was some respite in food inflation, at 7.86 per cent, in September, as against 9.14 per cent in August. But it is too early to conclude that this is a trend.

The only good news is from the domestic currency front. The rupee has been appreciating against the dollar after the measures taken by the RBI to check speculation and volatility early this year. The rupee is back at the 52 level against the US greenback after plunging to a low of nearly 58 in June. The rupee's appreciation lowers the danger of inflation seeping in through costly imports, especially of crude oil.

However, the recent liquidity boost by the US and European central banks to support their economies may drive up inflation by pushing up commodity prices, especially of crude oil. The excess liquidity is expected to flow into commodity markets.

So, in a nutshell, the danger of rising inflation still looms large over the RBI's shoulders.

Many expect the RBI to bow to pressure from the government because growth will be a casualty in an inflation-targeting regime. On October 25, C. Rangarajan, the prime minister's economic advisor, slashed India's gross domestic product (GDP) projection to 6 per cent from 6.7 per cent.

The Asian Development Bank predicts that India's GDP will grow at a much slower rate, at 5.6 per cent, in 2012/13.

There is also no dearth of advice from foreign shores. Recently, Joseph Stiglitz, the Nobel Prize winning economist, said that "inflation fears in India are overdone". He advised the RBI to cut interest rates and push growth.

The IMF, however, has said that monetary policy should stay on hold in India because of high inflation.

All eyes are now on Subbarao to see how he negotiates the inflation obstacle and locks step with his political masters.