Why India's Central Bank Resisted Pressure to Ease

The Reserve Bank of India's refusal to succumb to pressure to cut interest rates shouldn't be seen as a snub at the government; rather, the move implies that containing inflation remains at front and center, the central bank's deputy governor Subir Gokarn told CNBC on Wednesday.

Why India's Central Bank Resisted Pressure to Ease
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On Tuesday, the central bank left rates steady at 8 percent, choosing instead to cut the cash reserve ratio for banks by 25 basis points. The move triggered immediate criticism from Finance Minister P. Chidambaram, who had hoped for more aggressive easing measures from the RBI to support the government's current campaign of boosting growth.

The finance minister on Monday unveiled a five-year plan to cut the country's hefty fiscal deficit, a day ahead of the central bank decision, in hopes that the RBI would reciprocate with sufficient stimulus.

The government has been urging the central bank to lower rates for months now, especially since unveiling drastic reforms in September aimed at increasing investment in the country. A call the central bank has so far resisted.

Gokarn says while he recognizes that the government is an important "stakeholder" in its monetary policy, the central bank will not lose sight of its prime objective to keep inflation under control.

"The government is obviously an important stakeholder in the policy, and the RBI is quite sensitive to it, but we cannot ignore the fact that inflation is still high, and is likely to go up over the next three months," Gokarn told CNBC on Wednesday.

Wholesale price inflation, India's main inflation gauge, spiked to 7.8 percent in September – the highest level in 10 months – driven by the government's recent diesel price hike. During its policy review, the RBI raised its inflation forecast based on the wholesale price index (WPI) to 7.7 percent from its earlier estimate of 7.3 percent.

Gokarn, who is one of the four deputy governors at the central bank, said aggravating the risk of further price pressures with premature easing is unjustified, adding that a rate cut is unlikely until the upward trend in inflation reverses.

"When we look at the trajectory of inflation beyond December – the baseline scenario suggests it will show a steady moderation, and that is the scenario that gives us a little more space to start thinking about easing," he said.

The Reserve Bank last cut interest rates in April, when it lowered the repo rate by 50 basis points. It has cut the cash reserve requirement ratio for banks by 175 basis points since the start of the year, in an effort to ease liquidity in the banking system.

Deficit Target

While the government's new target to nearly halve the budget deficit to 3 percent by 2017 is seen as ambitious by many economists, Gokarn said he believes it is achievable.

"Making this commitment places an enormous obligation on the government's shoulders. If growth isn't going to be that fast, it will be a challenge, but it's not unachievable," he said.

"It puts pressure on the government to take action consistent with this roadmap, like expenditure cuts, tax reforms, like a GST (goods and services tax)," he added.

Discussing movement in the rupee – which fell 2.5 percent against the U.S. dollar in October, after rising 5 percent in September - Gokarn said this recent volatility is tied to the general risk-off sentiment by global investors.

"Even if we had continued to see domestic (reform) action, a strong global risk off will have taken it down," he said.

By CNBC's Ansuya Harjani