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Like the 1980s US Fed chairman Paul Volcker, India's new Reserve Bank of India (RBI) Governor Raghuram Rajan wants to wring entrenched inflation out of a moribund economy. A surprise repo rate hike won't win Raghuram Rajan many friends. But he has sensibly retreated from his predecessor D Subbarao's foolish plan to shore up the falling Indian rupee.
The former Federal Reserve chairman's tight monetary policy tipped the US economy into recession in the early 1980s, but succeeded in curbing double-digit inflation rates. Following in his footsteps, Raghuram Rajan raised the monetary authority's key policy rate by 25 basis points on Sept. 20.
Investors were shocked. Yes, inflation is high at 9.5 percent, but GDP growth is collapsing. Strip out government consumption, and real demand expanded only 1.4 percent from a year earlier between April and June. Combating the Indian stagflation with higher interest rates will mean an even bigger sacrifice of output. Stocks fell as much as 3 percent in Mumbai.
Yet, the central bank's focus on price stability is necessary. India's myriad state subsidies are inherently inflationary, as they pump cash into the economy without any commensurate increase in production. The federal budget deficit has reached 63 percent of the fiscal-year target in just four months. Recently announced spending cuts are unlikely to be enough to reduce the deficit in a stagnant economy.
Then there's the beleaguered rupee. To Raghuram Rajan's credit, he is reversing the ill-conceived defence of the Indian currency mounted by his predecessor Duvvuri Subbarao. Even while increasing the policy rate, Raghuram Rajan cut by 75 basis points the penal rate the central bank charges liquidity-starved lenders which borrow directly from it.
Subbarao's decision to jack up this rate by 200 basis points was ineffective. The rupee slid by 22 percent against the U.S. dollar between May and August. The higher rates did, however, raise the lenders' cost of financing long-term loans with short-term deposits and borrowings, effectively taxing a banking system already creaking under mounting bad loans.
Raghuram Rajan can hardly take success of his risky strategy for granted. The currency has stabilized for now, but another rupee slump will push inflation even higher by increasing the domestic cost of imported oil. And how much higher can Indian interest rates go before Raghuram Rajan's political masters stop him in