Politicians and central bankers have to work to convince people to trust them, and to believe in what they say and what they will do. One can be given the benefit of the doubt once or even twice if lucky, but the track record is ultimately the only litmus test of credibility. In the last few days, US President Barack Obama and Governor D Subbarao of the Reserve Bank of India (RBI), respectively, showed how to repair what was broken, and how to dilute what was already effective.
The current we-love-India approach by the president should be weighed against his lack of positive actions towards India during his first year in office. So Obama-fied is everyone in India that almost no one has asked a basic question: What did the president do for India in that first year? Not much, really. It is perhaps for that reason that the pro-India wooing now is so strong, almost as if amends are being made for the earlier oversight.
There are several win-win options for both sides, especially in commerce and technology, and, of course, the huge scope for American investment in infrastructure financing that India needs but cannot move rapidly enough to tap. Obama has made a compelling and convincing beginning on this trip, for example by finally backing India for a permanent seat on the UN Security Council. Still, it remains to be seen whether the president will fully walk the talk. Any loss in momentum will be a setback for what India had managed to achieve with former Presidents Bill Clinton and George Bush. Hopefully, the course correction by Obama will play out.
While President Obama was hard at work to gain more trust, the midyear policy review of RBI was an anti-climax, to say the least. It showed how a single act can substantially dilute the good that had been done so far in conducting monetary policy and in managing the growth-inflation dynamics.
The central bank hiked policy rates by 25 bps as was widely expected and correctly announced prudential measures to check lending to the property sector. It also offered more concrete signals that were later complemented by effective actions about liquidity management in order to ease the deficit that in recent weeks appeared overdone.
But the highly unexpected — and dare I say controversial — twist in the monetary policy was the exceptionally clear indication that the likelihood of further rate action in the immediate future is relatively low. In his post-policy media interview, Governor Subbarao indicated that “immediate future” meant around three months.
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The guidance of a three-month pause turned out to be too dovish as the markets were initially only interpreting that RBI will stay away from hiking rates at the December meeting. The policy statement reflects a bizarre contradiction of a central bank indicating upside risks to its inflation forecast but offering a dovish outcome of a three-month pause. In today’s teeter-totter world of global finance that is also linked with rising commodity prices, a three-month pause is a luxury that RBI may not be able to afford. Indeed, given what is already happening with international commodity prices, it appears highly quite likely that RBI might have to hike rates in January.
The interesting twist in the RBI’s trinity of words, actions and guidance is worth focussing on. For a central bank that has only added fuel to the already elevated concerns over inflation, the guidance of the long three-month pause has pretty much wiped out much of the good work it was beginning to achieve in managing inflation expectations in recent months, in my humble opinion. What most people remember about the policy is the guidance on the three-month pause, not the elevated concerns expressed about inflation and inflation expectations, or the hike in interest rates. Several market economists who had pencilled in rate hikes in November, December and January took off at least the December rate action following the RBI’s guidance. There is nothing like a central bank offering to do the work for you.
There were two main options going into the November 2 policy review, given that RBI had already indicated in the September meeting that it was close to a neutral policy rate. One, keep policy rates unchanged given how aggressive RBI had been in the prior three-four months, but remain hawkish on inflation, emphasise that the tightening cycle is not over. Under this scenario, RBI would probably have to hike again in December.
Two, hike 25 bps, remain hawkish on inflation, and emphasise that the tightening cycle is not over. Most likely, RBI under this scenario would have remained on hold in December. What we finally got was a hodgepodge of action and guidance that is much more dovish than being hawkish, and appears to go counter to the RBI’s efforts to manage inflation expectations. Indeed, if inflation is a problem and there are upside risks to the inflation forecast, then why offer such an explicit pause on rates, even if that outcome could occur? On the other hand, since monetary conditions have been tightened significantly over the last three-four months and we have not seen the full favourable effect of that tightening play out and there are already some favourable indications on inflation, then why hike now?
In the final tally, the policy delivered a compromise outcome that is not what a central bank singularly focused on inflation should offer. More importantly, having set a precedent of an explicit time-bound pause, is RBI as an institution now going to stick to this practice of time-bound guidance?
The WPI inflation data for October was already baked (although it is not public) before the policy announcement, and the one for November is unlikely to be affected so soon by the latest rate action. Headline WPI inflation will ease further through December, although the recent hikes in railway freight charges and petrol prices, and the upward march in global commodity prices are important headwinds that could limit the improvement.
In the final tally, RBI should perhaps better appreciate that it is a risk manager, and is not in the business of eliminating risks for financial investors, especially when it itself doesn’t know how the economic landscape will evolve. There are good reasons why time-bound guidance by central banks is not a mantra that is normally followed, and RBI should refrain from such explicit guidance, especially when global dynamics are so uncertain.
The author is senior economist at CLSA, Singapore. The views expressed are personal