RBI ensuring it does not fall behind the curve if inflation persists

Written by Shubhada Rao | Shubhada Rao | Updated: May 5 2011, 03:14am hrs
The runup to the monetary policy of the RBI was dominated by the debate of whether the central bank would continue with its calibrated approach or if it would take a bigger stride on interest rate front. In the last policy announcement, the shift of policy focus had emphatically tilted towards inflation management while acknowledging that the momentum in growth was largely intact. Since then, in over a month and a half, while upside risks to inflation grew, downside risks to growth due to inflation remaining at elevated levels gained traction in the economy. The resurgence of demand-side pressures in March, when inflation printed just short of 9% level, acted as a trigger. Notwithstanding the slowing growth momentum, a case for an aggressive rate action was building up.

The RBI in its policy announcement on Tuesday did depart from its preferred calibrated approach, delivering a larger dose of rate action while adopting the recommendations of working group on operating procedure of monetary policy. It hiked both repo and reverse repo rates by 50 bps each to 7.25% and 6.25% respectively. Additionally, RBI announced the repo rate to become a single independently varying policy rate, with reverse repo rate to be fixed at 100 bps below the repo rate and a new Marginal Standing Facility (MSF), instituted at 100 bps above the repo rate (which can be used by banks to borrow overnight up to 1% of NDTL). Through the new structure of policy rates, the RBI hopes to further improve the transmission of monetary policy and keep the volatility in call market in check while the guidance for tightening stance is expected to rein in demand-side pressures and anchor inflationary expectations.

The urgency to clamp down on inflation was evident in RBIs tone when it mentioned its aim to fight inflation quickly and decisively in the macro and monetary developments document released as a prelude to the policy. The rate action is a clear move by the RBI to align itself to prevalent and emerging upside risks to inflation. More than sticking to its anti inflation stance, RBIs move was more of coming to terms with acknowledging the likely persistence of inflationary pressures through 2011 and ensuring that it did not fall behind the curve.

In the presence of strong domestic demand-side pressures, it is important that monetary policy be accompanied by a strong resolve towards fiscal consolidation, which has strong upside risks given elevated crude oil prices and governments inability to deregulate petroleum prices. RBI has clearly conceded preserving sustainability of medium term growth an upper hand by prudently compromising growth in the near term as inflation at elevated levels has become entrenched.

Going forward, I hope that the aggressive rate hike will succeed in at least partially reining in inflation given some stickiness due to its larger imported component. Meanwhile, risks to growth have emerged on the downside in view of another 50-75 bps of hike in the repo rate which we believe will be delivered by the RBI in the course of FY12.

n The writer is chief economist at Yes Bank