Rate hike is rational

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SummaryThe primary reason for RBI to increase rates was to ward off the contagion in the financial markets

RBI hiked the repo rate by 25 bps against the market expectations of a status quo. We believe an outside chance of rate hike had not been entirely ruled out, given both RBI’s penchant for springing a surprise and the recommendations of the Urjit Patel committee report. Going by several policy actions, since September 2013, policy surprises have become the order of the day! The repo rate, if we only go by the RBI Governor’s statement on December 18, 2013, merits an increase (core WPI inched up marginally from 2.63% in November 2013 to 2.75% in December 2013). However, if we look at the long-term trends, an increase may not have been warranted, given that core CPI has remained flat at 8% since October 2013 and core WPI has actually declined from 2.96% in April 2013 to 2.75% in December 2013. So, what prompted the increase?

We believe the primary reason for RBI to increase rates was to ward off the contagion in the financial market. This has been sought to be done to make the arbitrage opportunities between foreign and domestic debt, adjusted for currency risk, more compelling in order to encourage FII debt flows back to India. With Brazil and Turkey already raising rates, there now seems to be a coordinated monetary policy action in January 2014, as was last seen in July 2013. Interestingly, the central banks of Indonesia and Brazil had raised rates in November 2013, and while it was widely expected that RBI will raise rates on December 13, such a hike did not materialise. So, it is entirely possible that the rate hike decision that was paused may have now been prompted with the apex bank watching the global situation very closely. To that extent, and given that the rupee has bounced back in the last two days, the rate hike may have been timely.

The policy statement also reflects a clear recognition of the fact that there are exceptions to the conduct of monetary policy under uncertainty. As was explained by the Governor in December 2013, in an uncertain world (referring to Brainard, 1967), the optimal value of monetary policy instrument depends crucially on the use of more information than what the policymakers may actually conceive (and hence the reference to the December 2013 inflation data softening at that time). It now seems such a rule may not be optimal when the central bank is

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