According to the RBIs Third Quarter Review of Annual Monetary Policy for 2007-08, it has achieved most of the objectives that it had set out to achieve. And while business confidence is sliding, Indias growth story appears intact. Thus, the central banks status quo on key policy knobs such as reverse repo rate, repo rate and cash reserve ratio.
A section of the market had expected an easing of monetary policy on January 29, given the US Feds aggressive rate cut of 75 basis points last week and expectations of another 50 on January 30 that would lower the Fed funds rate to 3%. If this happens, the interest rate differential between the US and India widens to 475 basis points, assuming that the current relevant policy rate for the Indian market is the repo rate, which acts as the chief signal.
However, by keeping rates unchanged, the RBI has focused on the domestic economy. It sees persistent aggregate demand pressures, evident in a distinct step-up in fixed capital formation as a proportion of GDP, even as consumption expenditure has declined. Upside inflation risks, to its mind, override the downside growth risks. Its reasoning Core WPI is higher than headline WPI inflation, and international crude prices reign high. Global foodgrain prices are high and likely to remain so. Money supply growth has remained strong at around 23%, against RBIs own projections of 17-17.5% for 2007-08.
The central bank also says that liquidity management would continue to assume priority in the conduct of monetary policy, and all policy tools shall be used in this context. Thus, while the RBI is unlikely to signal any further tightening of policy rates, any sharp increase in foreign capital flows can lead to CRR hikes to sterilise such flows. It has expressed some concern that higher capital flows have not led banks to reduce deposit and lending rates: Effective interest rates on time deposits at the margin are currently ruling above the Laf repo rate. I think this could be due to a wide interest rate corridor of 175 basis points between the repo and reverse repo rates. As rupee liquidity conditions swing swiftly from a surplus to deficit, the overnight call money rate moves from the lower end of the corridor (reverse repo) to the higher end (repo). Hence, most market rates on deposits and loans take their cue from the upper rate. Narrowing the Laf corridor could bring down market rates.
Overall, the policy continues to stand testimony to the RBIs overriding concern for domestic factors, while global conditions are also taken into account. Simply said, the central bank is unlikely to follow the Fed on interest rate directions, even as the differential continues to widen between the two economies. Given the current financial market volatility, which would influence capital inflows, it is very difficult to take a call on changes in the RBIs policy stance at the next meeting in April 2008.
So long as growth sees a moderation within acceptable limits but domestic inflationary expectations remain firm, the RBI is likely to maintain status quo on policy rates. As of now, I would assign a greater probability to no change in the April monetary policy announcement, unless of course domestic growth worsens significantly in the intervening period.
The author is with Kotak Mahindra Bank. These are his personal views