Central Banking Dilemma - Growth v/s Inflation

With the Indian economy apparently emerging from a situation of lower growth and higher inflation, there has been a widespread optimism about the country's economic prospects across the world. India has recently seen a relative pick-up in growth and improving outlook towards inflation, there has been an apparent shift in expectation from bankers as well as corporate houses in India towards a rate cut.

India is among the few countries in the high GDP group which is at the peak of its interest rate cycle with rest of the global central banks either having near zero interest rates or doing quantitative easing.

This leaves us to the question that why is there such a hugely deviant stance from the Indian central bank and the pros and cons of it.

A. The deviant stance

The deviant stance of India compared to rest of the Higher GDP group is as follows:

a. Difference in mandates of the central banks
While there are a lot of global banks who focus on employment or growth, the primary mandate of Indian central bank is Inflation. This primary mandate itself indicates that the main target is keeping the inflation low even if it leads to lesser growth or lower employment. Though this may be deemed as slightly defensive by most observers, it can be attributed partially to the stage of development of country's population most of which need low prices to ensure that they can satisfy their basic necessities.

b. Apparent demographic differences
While most countries in the "High GDP" bracket have a high HDI and great per capita income, India suffers from low (or rather extremely low) numbers in both these parameters indicating that the majority of population is near the poverty line and still focusing towards fulfilling their basic needs which mandates the central bank to ensure that they help in the process of achieving these goals by keep the inflation in check.

c. Internal and external factors
India has heavy dependence on oil and considering its volatility, it leads to huge amount of volatility in inflation and India's exchange bill which puts further strain on the central bank to ensure that that they do not react to short term movements in either and wait for a longer term trend to emerge which itself puts the bank on the defensive as the moves and decisions are generally lagging.

d. Background of the Central Bank governor
The central bank governor plays a very important role in decision making on rates and his overall background is a key element in the entire process. While the former RBI governor, Subbarao who came from a modest background and worked his way through the grass-roots, had been defensive and more inclined towards populist measures and targeting inflation. On the other hand, the current RBI governor, Raghuram Rajan who has been more exposed to global policies having worked with the IMF, is relatively more aggressive on rates.

e. Developed v/s Developing world
Generally it is observed that the interest rate cycle of the developed world leads that of the developing world by a few months as the effects of a developed rate changes generally lead to monetary outflows/ inflows from an emerging country and hence the central bank prefers having rate controls to prevent sudden volatility.

Implications and advantages / disadvantages  discussed in the next article.