Signs of normalisation

RBI signals it will not back down from inflation-fighting

As expected, the Reserve Bank of India maintained the status quo on policy rates in its bi-monthly policy statement yesterday. With the benchmark Consumer Price Index (CPI) inflation rate still holding stubbornly above eight per cent, it would have required a significant change of heart on the part of Governor Raghuram Rajan to do otherwise. This clearly was not on the cards. Having committed to a particular trajectory in its quest against inflation, it makes little sense to change it in the absence of any easing of inflation. In fact, the baseline projection of the CPI inflation rate for March 2015 is indicated at 8 per cent, which, effectively, rules out any rate cuts until then. However, the policy statement opens up some possibilities of that happening, stating that the risks around the baseline are evenly balanced. On the upside, the main danger is the El Niño threat to the monsoon, which can cause trouble through higher food prices. On the downside is the prospect of the new government getting to grips with the many supply-side problems and fiscal stresses that the economy is struggling with. On balance, though, it would perhaps be naive to expect the RBI to begin to stimulate demand any time soon.

However, while maintaining its stance on the policy rate, the RBI has taken a number of steps that reflect something of an easing as well as a signal that the currency situation is returning to normal. As regards easing, the statutory liquidity ratio (SLR) was brought down by 0.5 percentage point to 22.5 per cent of banks' net demand and time liabilities. This may not seem like much, but it achieves two objectives. One, it increases the banking system's capacity to increase credit quickly, should some growth momentum emerge. Two, importantly, it reduces the government's access to bank funds, creating one more incentive to contain the deficit. Expectations of normalisation on the external front are manifested by three measures. One, liquidity facilities against export credit have been rolled back and offset by an increase in unconditional facilities. Two, outward capital flow limits, which had been reduced during the rupee turbulence last year, have been partially restored. Three, foreign institutional investors (FIIs) are now allowed to hedge their rupee exposure in the domestic derivatives markets, with an additional allowance of 10 per cent. The last measure is likely to contribute significantly to market development.

In sum, on the monetary policy front, the RBI has stuck to its guns, asserting that it will not back down from its fight against inflation. This may, of course, get the government's back-up, but, as the RBI governor has made very clear, he alone decides monetary policy. The government would be well-advised not to go down the route of confrontation. It is far more important to begin to quickly address the supply constraints that are combining to keep inflation high. Only if the responses are visible and credible can the RBI justify a reversal in its position. Of course, in the absence of appropriate actions and the El Niño threat materialising may induce the RBI to tighten rather than loosen its stance over the next few months. As it has been for a long time, the ball is firmly in the government's court.