Unwinding begins, so does calibration

Written by Shubhada Rao | Shubhada Rao | Updated: Sep 21 2013, 09:11am hrs
In his maiden monetary policy, Raghuram Rajan reiterated Reserve Bank of Indias unequivocal focus on anchoring inflation through a surprise 25-bps hike in the repo rate. This was, however, executed deftly by a simultaneous partial reversal of the liquidity tightening measures instated since July. Encouraged by the recent stability in rupee, he thus strove to balance between the objectives of external sector stability, anchoring of inflation and inflationary expectations, whilst not abandoning concerns for growth.

The recent semblance of stability in rupee on account of collaborative measures announced by the government and RBI, along with Feds no taper for now stance, provided comfort to lower Marginal Standing Facility rate by 75 bps. Since a significant part of short-term market borrowing is through this window, the impact of higher repo rate would be completely offset by the reduction in MSF rate, thereby, lowering the weighted average cost of borrowing for banks. This will obviate the need for immediate transmission of hike in repo rate.

Caught in complex interplay of events since May 13, RBI was compelled to tighten monetary conditions to restore external sector stability even as weakening growth and moderating core inflation demanded a policy easing stance. However, with concerns on inflation resurfacing and the return of some stability to the external sector, RBI hiked repo rate, indicating that quelling inflation remains its priority for now. Retail inflation has continued to remain elevated at 9.50%, even as WPI inflation has flared up by close to 150 bps over the last three months. Much of this upside is, undoubtedly, driven by food pressures of late, but given the inflationary impulses lurking on the horizon (impending adjustment to fuel prices and lagged impact of rupee depreciation), RBI is left no room for complacency. As such, evolving conditions suggest that this is not the end of rate hikes.

The bigger question revolves around the implication of todays policy decision on future rate actions. In my opinion, as macroeconomic conditions permit, RBI is expected to balance normalisation of monetary conditions through one more round of reduction in MSF rate by 75 bps, along with a 25-bps hike in policy repo rate. However, the timing of RBIs actions would be largely governed by the developments on the external sector and, more importantly, on the inflation trajectory. In our assessment, the expected correction in CAD to around 3.6% of GDP in FY14 and the risk of a higher WPI, along with an elevated CPI inflation, will allow RBI to execute the aforementioned steps. With these conditions being met, RBI may look to restore repo rate as the operative rate for monetary policy.

The money market and long-term rates, nevertheless, are expected to settle at a higher level even in a normalised policy scenario, given RBIs anti-inflationary stance and upward trajectory of global rates. Nonetheless, the pace and magnitude of the rise is likely to be determined by the delicate balance between growth and inflation, as globally growth is on a recovery path whilst Indias current growth remains much below potential.

The writer is chief economist, Yes Bank. Views expressed are personal