e Reserve Bank of India has surprised markets by opting to keep benchmark interest rates unchanged and cutting the outlook for full-year growth in the wake of last month’s decision to withdraw legal tender status to high denomination currency notes. In the fifth bimonthly monetary policy statement, the RBI cited a “backdrop of heightened uncertainty.” It listed global factors including the imminent tightening of U.S. monetary policy and the rise in oil prices, and “disconcerting” domestic inflation trends that could potentially endanger its price stability goals. Expectations that the U.S. Federal Reserve will resume its normalisation of policy by raising interest rates on December 14 have combined with a homeward-bound flight of capital from emerging markets in the wake of Donald Trump’s win in the presidential election to buoy the dollar at the expense of other currencies. The rupee has not been spared, forcing the RBI to intermittently intervene to reduce volatility. Given that the exchange rate has the potential to exert upward inflationary pressure as a bulk of the country’s commodity imports, including crude oil, are largely paid for in dollars, the RBI had little choice but to ensure that at least interest rates don’t end up being another alibi for capital outflows. On the domestic front, food prices other than those of vegetables are showing sustained firmness. More worryingly, inflation excluding food and fuel has stubbornly displayed a “downward inflexibility” that could, coupled with volatile energy costs and further financial market turbulence, jeopardise the RBI’s end-March retail inflation target of 5 per cent.
That the central bank has adopted a “wait and watch” approach in the wake of the liquidity shock to the banking system sparked by the withdrawal from circulation of about 86 per cent of the bank notes, is instructive. Trimming its Gross Value Added (GVA) growth projection for 2016-17 by 50 basis points to 7.1 per cent, the RBI cited an unexpected loss of momentum in the second quarter, particularly in industrial activity, and the impact from the withdrawal of currency. The RBI observed that the currency replacement exercise was likely to have the biggest impact on cash-intensive sectors. The resultant disruptions could drag down growth in this fiscal and more data are needed before conclusions can be drawn on the full impact and persistence of such an impact. It is understandable therefore that the RBI has opted for caution. Observing that economic growth could rebound strongly if the impact is “transient” as widely expected, the central bank has for now chosen to hedge its bets by reiterating an “accommodative policy stance”.