The RBI’s decision to hike the repo rate (0.25 per cent to 7.50 per cent) in the September policy sprang a huge surprise. The overall message highlights at least three key points:
Strongly reinforcing the RBI’s inflation fighting credentials: The new governor clearly wants to reinforce the central bank’s inflation fighting credentials in an attempt to better anchor inflation expectations.
At the moment, headline (WPI) inflation is running at 6.1 per cent -- above the RBI’s desired level of around 5.5 per cent for the year. Retail (CPI) inflation remains stubborn at about 9.5 per cent. Interestingly, while core inflation (sub-2 per cent) is considerably softer and the recent uptick in WPI and CPI has been more due to supply-side issues such as food inflation, the central bank remains worried about the potential adverse impact on medium-term inflation expectations.
Thus, the repo rate hike (against market expectations) as an important signal to reinforce its inflation fighting credentials.
Normalising the near term interest rates to offer relief to the financial system: The cut in the MSF rate indicates that the central bank is willing to gradually phase out the excessive tightness in near-term interest rates in place since July 2013.
The governor, in fact, categorically mentioned that the MSF rate will be brought down over time to its usual level of just 100 bp higher than the repo rate. It seems, depending on the trajectory of the rupee and level of flows under the foreign currency non-repatriable (FCNR) deposit scheme, that this ‘normalisation’ will indeed take place during Q4 13. The RBI also emphasised that today’s move is intended to bring down banks’ near-term funding rates to a more sustainable level and, thus, should be seen as a positive for the banking system and the economy.
Sharing the responsibility of growth revival categorically with the government: Today’s RBI communication gives a hint that efforts to revive investment cycle and growth at the moment would not succeed alone with support from monetary policy, and would require strong support from the government.
The central bank has categorically flagged that inflation is higher than its comfort and household financial savings are lower than desirable. Such a guidance, in fact, does not preclude further hikes as well. Even so, the current action could be a one-off step rather than the first of a series of hikes.
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(The author is Chief India Economist, Barclays.)