Tamal Bandyopadhyay: Reading Reddy's mind

Interest rate is only one of the many monetary tools that the RBI uses to influence the market.

Last Saturday, Reserve Bank of India Governor Y V Reddy made two key observations. First, there would be no change in the central bank's inflation projection for 2006-07. At its annual monetary policy announcement in April, the RBI had projected 5 to 5.5 per cent range for the wholesale priced index-based (WPI-based) inflation for the year. Reddy admitted that the rise in prices of a few commodities was influencing the overall perception and inflation expectations but there was a commitment both at the global as well as the domestic level to contain inflation.

Second, he made it clear that there is no correlation between the monetary measures of the US Federal Reserve and the RBI. In other words, yet another rate hike by the Fed on June 29 might not influence the Indian central bank to tinker with its reverse repo rate in its quarterly review of monetary policy later this month. In Reddy's opinion, although global developments play a very important role, domestic developments continue to be the main factor that determines any decision to hike the rates.

However, these comments by the governor have not been able to soothe the frayed nerves of the bankers and bond dealers. They are not reading them as an assurance from Reddy that he would not do anything in the quarterly review of the policy to change in the interest rate outlook. After all, last month the RBI hiked the reverse repo rate by 25 basis points to 5.75 per cent within hours of the European Central Bank hiking its policy rate by an identical margin. A few days after the rate hike, Governor Reddy at a function in Pune had hinted that in a globalised economy, the RBI had to closely monitor what other central banks, particularly those of major economies like the US, do.

So, doesn't Reddy say what he mean? Or, is there a disconnect between speech and action? Should the monetary policy necessarily have an element of surprise to have an impact on the market? Reddy himself attempted to answer some of these questions at a Bank of England symposium in London on 23 June. Dwelling on the "delicate distinction" between monitoring and influencing inflation expectations on the one hand, and giving forward indication on the other, Reddy said: "We, in India, prefer to provide detailed information and share relevant analysis fully to influence expectations but are hesitant to give firm inferences from analysis or forward guidance.

Just a day before Reddy's talk, Bank of England Governor Mervyn King at the Lord Mayor's banquet in London had highlighted the dangers of a central bank trying to give forward guidance in this uncertain world. "The Monetary Policy Committee reaches a new judgement each month, made afresh in the light of all the new information about the prospects for inflation. We don't decide in advance. So trying to give direct hints on the path of interest rates over the next few months risks deceiving financial markets into believing there are definite plans for the next few months when no such plans exist," King had said.

The RBI, like other central banks across the globe, keeps its outlook on the interest rate too close to its chest and the market participants often fail to read Reddy's lips. There is nothing unusual about it. But what distinguishes the RBI from other central banks is the fact that it has too many weapons in its arsenal and often it uses them "" and not the interest rate "" to influence the course of the monetary policy. This confuses the banking community and the bond dealers but, as long as the objective is achieved, Reddy cares a damn about the means of achieving it.

For instance, in April, when every body "" except for the finance ministry "" was expecting a rate hike, Reddy refrained from doing it. Instead, he raised the risk weights and provisioning requirements by banks for certain categories of assets. The impact of these measures on banks' cost of funds was higher than a direct rate hike by the RBI. Hence, the banks had to hike their lending rates even though there was no rate hike by the central bank.

Similarly, the market was surprised by the June 8 rate hike. The yield on the 10-year benchmark government paper jumped to 7.8 per cent from 7.65 per cent following the 25 basis points hike in the reverse repo rate. However, the greater surprise came a fortnight later when the RBI raised the quantum of the auction of a scheduled government borrowing programme from Rs 5,000 crore to Rs 9,000 crore. The yield on the 10-year government paper leaped to 8.20 per cent from 7.80 per cent as panic gripped the market.

Essentially, Reddy used a highly unconventional tool "" the government's borrowing programme "" to influence the interest rate trajectory. While a 25 basis points policy rate hike led to a 15 basis points hike in the yield of the 10-year paper, the hike in the auction amount had a far higher impact as the 10-year yield rose by 40 basis points! It served the purpose of the central bank even though the market didn't particularly like the idea.

So, Reddy doesn't necessarily have to go for a rate hike when the monetary policy is due for a quarterly review later this month to widen the interest rate differential between the US and India, which has shrunk to a mere 50 basis points (with US Fed rate at 5.25 per cent and reverse repo rate at 5.75 per cent) since he can tighten the policy in many other ways. If he refrains from doing any thing, that will be another surprise for the market.