Not exactly a status quo policy

The credit policy announced is significant for two reasons, even though nothing has changed on the rates front. The language used and the explanation given highlight important facets of the policy rationale. First is that the economy is doing well and on the path of stable high growth, which will be 7.2 per cent. There is no change in the number which means that the RBI is more optimistic than the government, which had projected growth at 6.5-7 per cent for the year.

But the more far reaching implication is that it clearly indicates that the present interest rate stance cannot militate against growth. This is important because there is one school of thought, which was also voiced by some members of the MPC in the past, which believes that not lowering the repo rate will hurt growth. Therefore, this clarification was required and should assuage the markets.

The second significant point made was on inflation. There is again a school of thought which argues that interest rates cannot affect food inflation. As a corollary it is argued that when core inflation is low the repo rate can be cut even if food inflation is high. Here the RBI has provided three compelling arguments. The first is that the mandate is to target headline inflation and not core inflation. This is extremely important because core inflation is only a sub-component of the index and it would not be proper to keep dicing the index and taking views on how monetary policy can have an impact on these components. If headline inflation is the only target, there can be no deviation from the mandate.

Second, the statement has pointed out that as food has the highest weight in the index and is also what affects consumers, the related inflation number cannot be ignored. In fact, allowing it to be persistently high will create inflationary expectations that will in turn push up headline inflation in future. Last, the RBI has also explained that if left unchecked, food inflation will enter core inflation components too and hence push up headline inflation. Therefore pre-emptive action is required to ensure that this pass through does not take place.

Hence these two points made are significant and lays down the rationale for maintaining status quo on both the repo rate and stance again. It also justifies the RBI’s relentless pursuit of targeting headline inflation. In this policy the RBI has again buttressed the fact that while inflation will come down in Q2 of the year to 4.4 per cent, it would be more on account of the base effect and will rise once again to 4.7 per cent in Q3. Therefore, there is a hint that a rate cut is still far away. While all interpretations will be subjective, it does look like that even in October there would be an unchanged position unless the final data is much better than what has been projected. December could be the earliest point of time when the MPC could consider any change in either the stance or rate.

Another takeaway is that the market should not be looking for hints from what other central banks are doing. Often it is felt that if the Fed cuts rates so will the RBI. This time the RBI has stated upfront that there are differential actions being taken by various central banks and while some are cutting their rates or indicating such actions, there are others which are increasing their policy rates.

This should clear the air for the markets as, at times, they tend to go overboard and look to pick up signals from the Fed. This is notwithstanding the fact that the RBI has always maintained that it is driven by domestic considerations and not global actions of central banks.

Financial stability concerns

Another interesting takeaway in the policy statement is that probably for the first time the central bank has raised some red flags in the area of financial stability. While maintaining that the financial system was stable, it has pointed to some entities which may be overextending their exposures to top-up loans as also the personal loans for consumption purposes. While these are genuine business options, the message is that prudence has to be exercised to ensure that the sanctity of the system is maintained. There is also acknowledgement of the fact that banks are facing challenges on raising deposits as households are diverting funds to the market.

The policy hence is quite different from the earlier ones even though there has been no policy action taken. There are several clarifications made which explain the rationale behind taking these decisions. These arguments may be taken as being the clinching factors in arriving at the majority decisions, given that even in the past there have been members who had a different view which were related to both the ‘growth argument’ as well as ‘policy effect on food inflation’. As the markets did not really expect any change in policy it was not surprising that there was virtually no change in the stock indices, currency or bond yields.

There is also some messaging for banks when it comes to raising deposits as well as lending which will be taken seriously. The market has become competitive where banks are one part of the structure. With financial literacy spreading there will be a tendency among households to consider all options; as their level of maturity increases, they would like to explore the market. Therefore, the arena has become more crowded on both the lending and borrowing (deposits) side.

The writer is Chief Economist, Bank of Baroda. Views are personal