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 2016—half of what would be considered a neutral, full-employment rate. Has the Fed’s 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 RBI’s 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 direction—contingent 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 India’s yield curve. I have long believed that with the US yield curve relatively steep, India’s 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 rate—and 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 elevated—which I suspect it will given the expected pass-through from currency weakness to tradable sector prices—the central bank must not hesitate to raise the repo rate again to curb inflationary expectations. Let’s remember—central banks typically have just one instrument—the short-term interest rate. So, at best, they can achieve one objective—and that must be to keep inflation expectations low and anchored. There is no shortage of evidence around the