RBI governor Raghuram Rajan surprised the markets again by raising the repo rate by 25 basis points to 8 per cent as against expectations of maintaining status quo, in the monetary policy review on Tuesday. It, however, kept the cash reserve ratio (CRR) of banks unchanged at 4 per cent.
More importantly, the central bank based its decision on the high consumer inflation and referred to the recommendation made by Urijit Patel Committee (click here for more), which has called for making consumer inflation the cornerstone of monetary policy.
Even though consumer inflation eased to a three-month low of 9.87 per cent in December as vegetable prices fell as compared to 11.16 in November, it is much above the comfort zone.
The wholesale price index (WPI), the key determinant of monetary policy till now, rose 6.16 per cent in December, its slowest pace since July 2013 and much lower than 7.52 per cent rise in November.
But RBI noted that consumer inflation, as capture by consumer price index (CPI), excluding food and fuel has remained flat and wholesale inflation excluding food and fuel has risen.
In its policy statement RBI referred to the Urjit Patel Committee recommendation of a “glide path” for disinflation that sets an objective of sub 8 per cent consumer inflation by January 2015 and below 6 per cent CPI inflation by January 2016.
It cautioned that over the next 12 months, and with the current policy stance, there are upside risks to the central forecast of 8 per cent. “An increase in the policy rate will not only be consistent with the guidance given in the Mid-Quarter Review but also will set the economy securely on the recommended disinflationary path. The extent and direction of further policy steps will be data dependent, though if the disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture,” RBI said.
“In fact, if inflation eases at a pace that is faster than we currently anticipate, and that reduction is expected to be sustained, the Reserve Bank will have room to become more accommodative,” Rajan said in a separate statement.
The 30-stock benchmark index S&P BSE Sensex sank over 1 per cent soon after the RBI hiked the rate but recovered thereafter.
In the mid-quarter policy review last month RBI had decided to hold policy rates when the street anticipated a hike.
Assessment
The central bank noted that the global recovery is gaining traction but uncertainty continues to surround the prospects for some emerging economies, with domestic fragilities getting accentuated. “Financial market contagion is a clear potential risk,” it added.
RBI said that in India some loss of momentum of growth is likely in Q3 of 2013-14, despite a strong pick-up in rabi sowing. “Industrial activity remains in contractionary mode, mainly on account of manufacturing, which declined for the second month in succession during Q3. Consumption demand continues to weaken and lacklustre capital goods production points to stalled investment demand,” according to RBI.
It added that the fiscal tightening through Q3 and Q4 is likely to exacerbate the weakness in aggregate demand and lead indicators of services suggest a subdued outlook, barring some pick-up in transport and communication activity.
RBI said the current account deficit for 2013-14 is expected to be below 2.5 per cent of GDP as compared with 4.8 per cent in 2012-13.
“The recent resumption of portfolio flows, both equity and debt, alongside the pick-up in FDI and external commercial borrowings that is underway should help finance the current account deficit comfortably,” it said.