Confidence in macroeconomic management is hard to gain, but easy to lose as the recent unfolding of events in India seems to reflect. Confidence is an outcome of confluence of several factors: positive expectations about the performance of domestic economy in terms of growth, price stability, fiscal discipline and consolidation and above all the faith in political stability and governance. Such expectations have the spill over effect on to the external sector which can turn adverse very quickly in the face of a confidence deficit.

The mid-quarter review of monetary policy maintaining the status quo on policy rate and the reserve ratio (CRR) gave a jolt to the market since this stance was least anticipated. But, it also came with a strong hawkish message that under the current environment there was no scope for immediate further easing of policy stance. Taking together Reserve Bank of India's (RBI) measures since the easing signal began towards the end of 2011, followed up by very aggressive CRR cut by 125 basis points (bps) and a hefty policy rate cut by 50 bps till April 2012, one must acknowledge that the RBI acted consistently, credibly and courageously. RBI should be commended for maintaining such a stance which is most appropriate but to the wrath of some important stake holders.

At a time when inflationary pressures have not subsided and the prospects of growth of Indian economy during the current period is not that bright, the Indian banking system is facing the trilemma of balancing between liquidity, capital and return. The slower deposit growth partly explained by high inflation and substitution of bank deposits by households with inflation hedging products like gold and real estate has caused a dent in availability of liquid resources to the banking system. Afflicted with growing non-performing loans and higher provisioning requirements inter alia due to pension liabilities, banks have been put under the radar of Basel III requirements at a faster and tighter pace than the agreed international requirements for compliance.

The monetary policy statement by Governor Subbarao for the year 2012-13 assumes critical significance at this juncture for two reasons. First, it offers to provide the tone of policy setting for the fiscal year 2012-13 as a whole and will generate expectations that would be difficult to reverse in the short run; and second, the policy is announced at a time that the Indian economy is facing multiple downside risks namely persistent and sticky inflation at an elevated level, weakening external sector in terms of current account deficit, depreciating currency and declining reserves position, and the fiscal laxity posing the challenge of managing a huge additional borrowing programme.

It was widely expected before the presentation of the budget for the year 2012-13 that the central government would come out with a credible fiscal consolidation path so as to return to the fiscal rules under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. This confidence was belied. Since further amendments are proposed to the FRBM Act, to suit the new fiscal paradigm, practically the central government seems to have given an indefinite holiday to sustained effort in consolidating its fiscal position. Doubts have already been raised about even the marginal reduction in fiscal deficit number for 2012-13. Therefore, the loud signal that comes out of the current budget is that the fiscal deficit is likely to be sustained at a higher level in the immediate future.

For historical reasons, India has the unique practice of adopting inflation rate based on wholesale price index (WPI) for policy purposes against the common international practice of following consumer price index (CPI). This is for a variety of reasons: first, the available CPI series are not representative of all classes of people; second, CPI coverage is limited to consumption basket, whereas the coverage of WPI is all inclusive, and third, till recently WPI series were available at high frequency of weekly intervals and with a shorter time lag compared to CPI. Since the most popular CPI is for industrial workers, CPI (IW) is extensively used for wage indexation, while for a variety of other policy purposes, WPI is largely used.

While the fiscal responsibility legislation was passed by the central government in 2003, all the states have passed corresponding legislations by 2010. The burden of financing of fiscal deficit is increasingly shouldered by domestic market borrowing of both states and the centre. While prudent fiscal management is a joint responsibility of states and the centre, because of the subordinated position of states in raising market borrowings, it is the central government that should show in a demonstrable manner the way for fiscal consolidation.

The Reserve Bank of India (RBI) has come out with much expected pause in policy rate hikes in its mid-quarter review of monetary policy announced on 16 December 2011. A reversal in stance at this time would not actually mean any immediate reduction in policy rates, but only a pause in rate hike that sends a signal that the policy rate has peaked, and it is time to allow the lagged impact of past rate hikes to work themselves out.

As almost culminating in full interest rate deregulation, the Reserve Bank in its October 2011 policy announced that the banks are free to determine their savings bank deposit interest rate (SBR). RBI has also fixed a threshold size of Rs one lakh up to which a uniform rate will apply and beyond that level, the banks are further free to apply differential rates. Though apparently there was opposition to this move particularly from the public sector banks, the Reserve Bank needs to be commended the way in which it prepared the ground for deregulation well ahead by releasing an excellent discussion paper and inviting public comments. For obvious reasons, the non-resident deposits will continue to be administered and freeing of those rates has to await full convertibility of the rupee. Yet another set of rates on small savings schemes of the government, though remain regulated for practical reasons, these rates also have been bench marked against appropriate market related rates in the system.