Dovish side of a hawkish RBI

Written by Shubhada Rao | Updated: Oct 30 2013, 09:32am hrs
The unconventional monetary policy measures ended in SQR of Monetary Policy FY14 with restoration of 100 bps corridor between the LAF repo rate and MSF rate. In line with expectations, LAF repo rate was raised by 25 bps to 7.75% along with a similar reduction in the MSF rate to 8.75%. With concerns abating on the external sector vulnerabilities for now, along with the attendant currency volatility, RBI has reversed with agility, the extraordinary tightening conditions imposed on the money markets. I am tempted to reiterate the intense currency volatility was contained with measures attracting capital flows since early September (with support from Feds taper procrastination) and not as much by interest rate defence mounted in mid July.

The key takeaway from both, the MMD report and the monetary policy statement is the return to RBIs unwavering policy focus on inflation management and anchoring inflation expectations. An array of factors viz inefficient supply management of primary food articles; risks of persistent food & fuel inflation spilling over to broader price pressures through wage cost inflation; pass-through of rupee weakness, among others have driven both WPI inflation and CPI inflation to levels that carry the risk of jeopardizing growth prospects beyond redemption. While the average headline CPI inflation has remained above 9.5% largely on account of elevated food & fuel prices, greater concerns emanate from the sticky core CPI inflation that has averaged around 8% in the current financial year despite weak demand conditions in the economy. The inclusive approach in encompassing all inflation indices with larger focus on managing CPI inflation indicates RBIs deep concern on adverse impact of high and entrenched inflation expectations on financial savings.

With focus now shifting towards inflation management, the onus of improving growth environment rests with the government, with focus on enhancing structural reforms, thrust on project implementation, thereby, easing supply constraints. However, it is commendable that monetary policy has not remained passive towards supporting growth. With inflation concerns constraining any direct interest rate support, RBI has ensured adequate liquidity through multiple windows while simultaneously working towards lowering the weighted average cost of funds for the banking sector.

In this context, RBI sprung a positive surprise by enhancing the limit under term repo facility from 0.25% of NDTL to 0.50%. Besides helping to deepen financial markets in the longer run, this will provide additional liquidity of R20,000 crore, thereby, reducing the reliance on the MSF window. As the MSF window utilisation recedes, the term repo rate would get anchored at levels close to the repo rate from its current level of 8.71%. This will further bring down the weighted average borrowing cost for banks.

The next step in monetary policy will be largely driven by incoming data on inflation and growth. Any adverse deviation from the expected trajectory of inflation as outlined in the policy statement will compel the RBI to maintain a tightening bias despite suboptimal growth. In contrast, policy challenges will accentuate if growth disappoints sharply. The next monetary policy step is not an open and shut case yet.

The author is chief economist, Yes Bank