End of tightening, new policy framework begins

Written by Shubhada M Rao | Updated: Jan 29 2014, 09:36am hrs
Belying consensus expectation of a status quo, the RBI hiked repo rate by 25 basis points to 8.0%. Before getting into the perfunctory analysis of the motive behind the same, let me emphasize that the rate hike in my opinion is less important in the overall scheme of things.

This is because proactive management of liquidity conditions through open market operations and the term-repo window would lower the impact on money market rates. In addition, the forward guidance provided by the RBI has nearly ruled out the need for further incremental tightening. This explains why after the initial kneejerk reaction, the stock market ended nearly flat while government bond yields were actually lower by the end of the trading session.

In my opinion, January policy review will not be remembered for signaling the end of rate hike cycle that started in July 2013. It will however be remembered as an important milestone in Indias evolving monetary policy path due to a variety a reasons.

First, January 2014 policy review has kick started the process of migration to the revised monetary policy framework as outlined by the Patel Committee Report. While the recommendations are still being evaluated, the setting of the monetary policy tone with the objective of attaining 8% CPI inflation by January 2015 clearly highlights RBIs willingness to move towards a more transparent and accountable monetary policy regime. In addition, the RBI announced a reduction in the number of policy reviews from 8 per year to 6 per year, a two-monthly cycle beginning April 2014.

Second, while headline CPI inflation is important, so is core CPI inflation. Despite the significant decline in headline CPI inflation owing to disinflationary pressures in vegetables and fruits prices, core CPI inflation continues to remain sticky at elevated levels. The rate hike by RBI is expected to curb the anticipated upside risks to core inflation emanating from increase in order books, pick-up in capacity utilisation and a decline in inventories

Third, CPI inflation going forward will gradually replace WPI inflation from a policy perspective. This is evident as RBIs WPI inflation estimates were innocuously absent from January 2014 policy documents, a departure from the usual practice.

Fourth, the policy decision appears to have been tilted in favour of a rate hike by the recent gyrations in the global financial markets led by stress in emerging economies. The clear risk of a potential financial market contagion may have led the RBI to nip the brewing risk in its bud. This highlights RBIs proactive rather than the usual reactive approach to external risks.

A proactive central bank with a keen eye for inflation risks and financial market stability is what India needs in an environment where policy credibility and capability is getting questioned in some of the emerging market economies.

Having said that, one also needs to appreciate the important role played by fiscal policy. In Indias case, where fiscal policy dominance that complicated monetary policy decision making in the recent past, has started to turn for the better.

Despite the noise one hears on procrastination of expenditure, fiscal position has been in a consolidation mode, albeit at a slow pace. The usual inflation sparks provided by the government in the form of MSP increases and rural spending have come under serious check in FY14. In addition, government has fast tracked project clearances, which is expected to start reviving investments from FY15 onwards.

While this is a welcome move, further fiscal and administrative coordination with governments persistence on the path of prudent policymaking will be a key requisite for allowing the monetary policy framework to move on the path recommended by the Patel Committee Report. The RBI has taken the first step towards this in January. Lets hope the government follows suit later in 2014.

The writer is a senior president and chief economist at Yes Bank