A surprise from the RBI

In its third quarter review of monetary policy, the Reserve Bank of India sprang a big surprise by hiking the policy repo rate by 0.25 percentage points to 8 per cent. All other rates — the bank rate, the

reverse repo and the marginal standing facility rates — stand adjusted upwards. Unprepared as the financial markets might have been to the hike, the central bank’s justification is unassailable. In the mid-quarter review on December 18, 2013, the rates were kept unaltered, anticipating a cool-off in vegetable prices. With the subsequent fall in food prices, especially of vegetables, headline inflation has fallen significantly and might stay subdued well into the next round of data compilation. However, excluding food and fuel prices, CPI inflation has remained stubbornly high while core WPI inflation has risen, although only marginally. As RBI Governor Raghuram Rajan said subsequently, behind its logic has been the CPI inflation which remains close to 10 per cent and is the prime cause for the hardening inflation expectations among consumers. Besides, there is evidence to show that notwithstanding the tight monetary policy, aggregate demand pressures are still exerting upward pressure on overall inflation. A rate hike is justified, though the growth momentum is weak and there has been much fiscal tightening in the last quarter of this year.

The other important development has been the release of the Urjit Patel committee’s report which has suggested that price stability should be the primary objective of monetary policy and towards that end CPI inflation should be brought below 8 per cent by January 2015 and below 6 per cent by the following year. Formal inflation targeting has not been adopted yet, but clearly the central bank’s increased reliance on the CPI is evident in its hiking the repo rate to firmly nudge the economy towards the recommended path of price stability. The Governor has emphasised that in the long run there is no conflict between its two traditional objectives of supporting growth and maintaining price stability. Unless inflation is brought down there cannot be a revival in either consumption or investment. Further policy steps will be data dependent but if the disinflationary process evolves as projected, any more tightening in the near term is not anticipated. The economy will grow at slightly below 5 per cent this year, but can firm up to 5.5 per cent in a range of 5 to 6 per cent in 2014-15. A pick-up in investment and stronger export performance might push up growth rates further. The external situation remains uncertain — global economic growth has been uneven and emerging economies have been under pressure in recent months.