What came out very clearly from the policy note was the increased emphasis on price stability. The central bank is clearly focused on containing "inflation" and moderating inflation expectations.
What's more, is the fact that the central bank does not even have the support of a strong currency at the moment. A strong rupee had been one of the central bank's first line of defence against imported inflation.
The rupee has lost almost 4% since the last credit policy was announced, largely due to the confluence of portfolio flows tapering off, and the US dollar gaining strength against major global currencies.
Additionally, during the July policy review, the Reserve Bank of India (RBI) had the benefit of computing inflation numbers on the base of the previous year ("the high base effect"). Towards the end of September, this trend too has reversed and the full force of inflationary pressures is expected to manifest through the rest of this fiscal.
Consequently, and in line with the broad market expectations, the reverse repo and repo rates have been hiked by 25 basis points, after considering the overall macro-economic pressures being faced on several fronts in the wake of strong growth momentum. Indeed, GDP projections have been further revised up to 7.50% in this policy.
What remains to be seen is what would be the appropriate timing for a change in the medium term monetary policy stance through a hike in the bank rate. Our view was that the RBI should have moved in to hike the bank rate in the wake of:
(a) global tightening cycle, with US Fed Funds Target rate clearly heading past the 4.5% mark;
(b) Worsening balance of payments position with expected current account deficit of 3% , and trade account deficit of 6% - the central bank has expressed concerns over the change in the balance of payments dynamics, stating that the current account deficit appears to be 'manageable'. However, declarations that "the trade deficit is emerging as the key determinant of India's balance of payments" and that "the evolving developments in the balance of payments warrant careful and continuous monitoring" are quite revealing and cast a seed of doubt on the 'manageability' aspect.
(c) rising inflation, with a serious risk of breaking out of the 5-5.5% level expected by RBI as a result of demand pull pressures brewing.
The strong growth impulses in the economy will surely lead to pressure on inflation from manufactured products. Not only that, concerns about a potential secondary round impact on inflation from higher oil prices persist.
Lastly, major central banks across the world are beginning to mount the rhetoric on inflation, and therefore interest rates. The US Fed has become decidedly hawkish, as have Asian Central banks. Europe too, has begun to digest oil price hikes well. The European Central Bank is unlikely to cut rates in the short term in the interest of managing inflation, rather than focus on growth alone.
In sum, the attention of the Indian central bank is clearly on "inflation". RBI has moved in time, on a precautionary basis to rein in potential pressures for now. What remains to be seen is what would be the appropriate timing for a change in medium term monetary policy stance through a hike in the bank rate. We felt it was now.
The author is president, financial markets, YES Bank