Markets disappointed but RBI does the right thing PDF Print E-mail
Saturday, 06 October 2018 00:00
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Shobhana edit

By leaving the key repo rate unchanged at 6.5% on Friday, RBI has made it clear it doesn’t want to stray from its core mandate of inflation-targetting. Certainly, the continued depreciation in the rupee will raise inflation, but as RBI has pointed out, retail inflation has significantly undershot the central bank’s projections—indeed, it has continued to do so for a long time. While RBI had projected a 4.6% retail inflation for Q2FY19, with July CPI at 4.2% and August at 3.7%—primarily because of very low food inflation—RBI is now looking at Q2FY19 inflation being around 4% (and 3.7% if HRA for government employees is stripped out as it should be). CPI for H2FY19, which was earlier projected at 4.8%, has been lowered to 3.9-4.5%; and the 5% projected for Q1FY20 has been lowered to 4.8%.

However, since there are many imponderables, RBI has left room to manoeuvre by changing its stance from neutral to ‘calibrated tightening’—the imponderables include the combined fiscal deficit being breached, oil prices rising further, the rupee weakening and the impact of the government’s MSP plan, should it really work and raise farm prices. While the new policy stance will allow RBI to raise repo rates, the current pause is probably aimed at giving the MPC time to assess the impact of the two consecutive hikes taken.

While the currency markets were disappointed that RBI had not used interest rates to defend the currency—the rupee crashed below the 74 mark—this newspaper has argued an interest-rate defence won’t work and might even backfire. The rupee has not depreciated merely because of the widening CAD but also because the dollar has strengthened on the back of the tightening by the US Fed; indeed all emerging market currencies have lost value against the dollar in the last few months. Indeed, as Sonal Varma, chief economist at Nomura, argues, the global evidence on interest rate hikes helping to stabilise currencies is mixed at best. Apart from the fact that a rate hike will hit equity flows that respond positively to a hike in growth expectations, she argues this will also hurt banks’ profits by pushing up costs at a time when borrowers have stressed balance sheets anyway. If stock markets collapsed after RBI’s status quo—but change in stance—it was for fear that, with no RBI measures, the rupee could continue to fall.

Hiking the repo right now was also unnecessary since interest rates are already rising in the system; the yields are high, and banks are raising loan rates because attracting deposits has been expensive. The money markets are becoming tight with a dozen banks effectively not doing any business, and large outflows of foreign money from the bond and equity markets. Also, while growth has been picking up, the recent tightness in the money markets, the elevated crude oil prices and slowing global growth will undoubtedly lead to a moderation in domestic growth, something the classic interest-rate defence is supposed to do.

The central bank has done well to announce liquidity infusions—Rs 36,000 crore in October—which will calm the bond markets where short-term rates have seen sharp increases over the past two weeks. Indeed, ensuring enough liquidity in the busy season should be the central bank’s priority, particularly since the government may not end up spending as much as it had planned to given the likely revenue shortfalls. While the output gap may be narrowing, there is substantial unutilised capacity so as not to unduly stoke inflationary pressures. Indeed, unless demand growth picks up pace in the second half of the year, inflation will remain subdued.



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