Inflation-warrior Rajan hits the pause button on interest rates

RBI hints at keeping repo rate steady if inflation eases

There were no surprises from Reserve Bank of India (RBI) Governor Raghuram Rajan on Tuesday — April Fools’ Day. Since taking the helm at the central bank last year, Rajan has repeatedly surprised the markets by holding the repo lending rate steady when everybody has expected a hike and going for a hike when all have thought no change is on the cards.

However, in RBI’s latest policy, Rajan kept the key interest rate unchanged, as expected, and indicated he would keep rates steady in the near term if inflation eased towards RBI’s targeted level. The repo rate remains eight per cent and the cash reserve ratio four per cent after Consumer Price Index-based inflation rate fell to a 25-month low in February.

Stocks were little changed on Tuesday after the monetary policy decision, while the bond and foreign exchange markets were closed.

As in his earlier monetary policies, Rajan didn’t forget to sound a note of caution on inflation resurfacing due to the possibility of a less-than-normal monsoon and uncertainty on setting the minimum support prices for agricultural products and other administered prices like those for fuel, fertiliser and electricity. “The policy stance will be focused on keeping the economy on a disinflationary glide path, intended to hit an eight per cent retail inflation level by January 2015 and six per cent by January 2016,” he said.

Rajan also cited risks to growth, noting early signs had yet to indicate a sustained revival for industry and services.

He said there was downside risk to the five to six per cent economic growth estimate for the financial year that began this month. There was another risk factor as well: “If electoral outcomes fail to provide a stable government, the downside risks to growth could accentuate,” the RBI said in its policy statement.

In its first bi-monthly policy review, a format suggested by the Urjit Patel committee, the RBI also implemented some of the other recommendations of the panel, which was set up to review and strengthen the monetary policy framework. For example, the central bank adopted the retail inflation as the anchor inflation, explicit recognition for the “glide path for disinflation” and reducing banks’ dependence on overnight funds through the liquidity adjustment facility (LAF) window.

The central bank has projected eight per cent retail inflation by January 2015 and six per cent by January 2016, while the rate of economic growth for 2014-15 is seen between five per cent and six per cent.

Experts said if inflation followed the projected ‘glide path’, the RBI might start cutting interest rates, as growth would continue to be weak. “If growth is no more than five per cent for a couple of more quarters and the retail inflation heads below seven per cent, there will be room for the central bank to cut rates in the fourth quarter, in our view. But given the signals sent out by the RBI lately, inflation and growth would have to decline substantially and persistently for any easing to be entertained,” Deutsche Bank said in a note to its clients.

Since taking office in September, Rajan has raised the repo rate three times, by a total of 75 basis points.

In a move to impose more discipline on lenders and in line with the global practice, the central bank cut the amount of overnight funding it makes available to banks, nudging them to use longer-term funding in a push to deepen financial markets. While the move to reduce availability of overnight funds to banks could spur near-term volatility in daily interbank lending and borrowing rates, it hastens the process of banks becoming more responsive to monetary policy action.

The central bank, however, reduced the availability of funds through the overnight LAF window by capping it to 0.25 per cent of banks’ net demand and time liabilities (compared with 0.50 per cent), though it increased the availability through the seven-day and 14-day term repo windows to 0.75 per cent of NDTL (from 0.50 per cent earlier). The move was aimed at improving the transmission of policy impulses across the interest rate spectrum. Analysts said this would impact banks’ cost of funds by 10 basis points.

“It will lead to slightly higher costs because it is going to come in at near repo, near policy rates but not at policy rates. So, to that extent, if I am borrowing now from the repo window, I would instead be borrowing at the term window. The term window will obviously be a little more costly. So it will have some impact on the cost of funds,” State Bank of India Chairman Arundhati Bhattacharya said, adding that the bank was yet to work out the impact of the move.

Besides, in a move to make markets more attractive by allowing global investors to use derivatives more widely to limit losses from rupee swings, the RBI plans to let foreign investors protect the interest income on bond holdings for up to 12 months. The central bank said it was also in talks with the capital markets regulator to finalise steps to enable overseas funds to hedge the currency risk by using exchange-traded rupee futures.

“The Reserve Bank will continue to work on making the entry easy, while reducing risk to foreign investors from the volatility of flows,” the RBI statement said.

The RBI added it also sought to let resident individuals and firms with foreign-exchange exposures buy derivative contracts of up to $250,000, subject to conditions. It didn’t elaborate on this.