Column: Balanced and pragmatic

Written by Sajjid Chinoy | Updated: Sep 21 2013, 10:17am hrs
It would have been easy to overreact. The Fed had thrown all emerging markets an unexpected lifeline on Wednesday. Tapering was pushed out and the Fed funds rate was only projected to be 2% in 2016half of what would be considered a neutral, full-employment rate. Has the Feds reaction function turned more dovish Domestically, the rupee is 10% stronger from its lows, capital inflows have begun to trickle back in, growth momentum is abysmally weak, and the recent surge in inflation could have all been blamed on onion prices. In sum, it would have been tempting for RBI to simply dismantle the entire interest rate defence and cause the yield curve to gap down, on the basis that the exchange rate objectives had been achieved.

To RBIs credit, it did not succumb to this temptation. Yes, the liquidity tightening measures were partially unwound. But it came with the proviso that further moves could be in any directioncontingent on how the exchange rate evolves. More importantly, RBI raised policy rates by 25 bps to send an unmistakable signal that (1) the interest rate defence of the currency would not be completely abandoned but simply moved to the more orthodox signal of using the policy interest rate (a la Indonesia), and (2) RBI will not tolerate retail inflation close to double digits and WPI inflation gapping up to 6%.

In so doing, RBI has begun the process of normalising Indias yield curve. I have long believed that with the US yield curve relatively steep, Indias inverted yield curve is incompatible in the medium term. But, given the inflation and currency dynamics that India faces, the normalisation would need to happen not just from reducing the marginal standing facility rate, but also hiking the repo rateand RBI must get credit for biting that bullet.

Now this process must be taken to its logical conclusion. The central bank seems inclined to systematically unwind the liquidity squeeze contingent on the exchange rate being supported. But if inflation continues to remain elevatedwhich I suspect it will given the expected pass-through from currency weakness to tradable sector pricesthe central bank must not hesitate to raise the repo rate again to curb inflationary expectations. Lets remembercentral banks typically have just one instrumentthe short-term interest rate. So, at best, they can achieve one objectiveand that must be to keep inflation expectations low and anchored. There is no shortage of evidence around the world to show that a sustainable pick-up in growth is predicated on macroeconomic stability and low inflation expectations.

Markets continue to obsess about whether RBI will focus more on the CPIas evidenced by the number of different ways this question was posed to the Governor at the press conference. Undoubtedly, the CPI has a very large weight of food, over which RBI has little control. But to the extent we bemoan surging gold imports that pressure the current account, and low deposit mobilisationcan we really ignore 10% retail inflation, which underpins these phenomena

In sum, given the constraints RBI was undera stagflationary dynamic at home, pressure on the currency, continuing global uncertaintywe got the best we could have hoped for.

All that said, lets not forget thatlike other emerging marketsIndia has caught a break from the Feds unexpectedly dovish stance. But this should be viewed as merely some breathing space not an elixir.

There is a risk that with capital inflows resuming and the currency being supported, the pressure to continue addressing the twin deficits is released. But its important to remember that the current level of the exchange rate is deceptively strong because it does not include a significant chunk of oil demandwhich will have to eventually return to the market. Its therefore critical that recent policy urgency in Mumbai and Delhi be maintained. For starters, authorities will do well to increase domestic fuel prices as a tangible sign that they mean business on the fisc. The current account deficit has narrowed, but largely on cyclical reasonsas the global growth pick-up has boosted exports while Indias weak growth momentum has impinged on exports. Its only when retail inflation is brought decisively under control will the demand for gold organically moderate.

Similarly, it's only when supply bottlenecks are alleviated will the expenditure switching from a sharp real depreciation be facilitated. So, Indian policymakers will be well served by taking the hard decisions on the fiscal deficit and retail inflation in the coming months. And the mix of financing the current account deficit needs to be dramatically changedaway from speculative flows towards more FDI and sticky, real money portfolio flows. So, the urgency for domestic reform should not be compromised just because we have got a lucky external break.

The taper will eventually come. Make no mistake about it. And when it happens, we need to be better prepared than we were in May.

The author is chief India economist, JP Morgan