Switching from soft to neutral stance

 By Subir Gokarn, Chief Economist & Roopa Kudva, Executive Directo and Chief Rating Officer, Crisil  The monetary policy statement signals a switch from a soft to neutral stance in the monetary policy.  It seems to be driven by two sets of concerns. For one, the Reserve Bank of India (RBI) has been signaling its discomfort with continued bond price inflation.  Its aggressive open market operations over the last few weeks and statements from senior RBI officials have attempted to curb liquidity and talk yields down.  This policy is in keeping with this strategy since it neither injects fresh liquidity (thus no cuts in CRR) nor does it signal lower rates.  Concerns about possible overheating of the economy and associated inflationary pressures are also in the background and the central bank seems unwilling to create a monetary overhang.  Its year-end inflation target of 4-4.5 per cent may be a downward revision from its own earlier target of 5-5.5 per cent but remains higher than the consensus (Crisil forecast is 2.9 per cent).  The neutrality in monetary policy could be motivated by the relatively pessimistic prognosis of inflation.  Crisil believes that the policy has two important implications for interest rate and exchange rates.  The absence of any liquidity enhancement measures marks the inflection point of the interest rate cycle and rates are likely to harden immediately.  A large section of the market had priced in a cut in both the CRR and the bank rate and the response to the absence of these measures is likely to be a sell-off in bonds.  Given the fact that the overvaluation of bonds was more at the long-end, the correction is likely to be more at this end. In the immediate term Crisil expects a 15-20 basis point rise in the yield spread.  The immediate hardening of interest rates and the absence of any other measures to stem appreciation could mean that the upward momentum of the rupee is likely to continue in the short term.  The policy