The Indian central bank surprised markets again by holding key policy rates in its mid-quarter monetary policy review on Wednesday despite the spectre of rising inflation in the economy boosting stock markets.
It kept the policy repo rate unchanged at 7.75 per cent and the cash reserve ratio (CRR) of scheduled banks unchanged at 4 per cent of net demand and time liability (NDTL). Consequently, the reverse repo rate also will remain unchanged at 6.75 per cent, and the marginal standing facility (MSF) rate and the bank rate at 8.75 per cent.
In his first mid-quarter policy review in September RBI chief Raghuram Rajan had surprised the markets with a rate hike which spooked investors. He went on to raise the rates again in October in light of mounting inflationary pressure.
However, in the latest policy review he held back the rate hike even as the headline inflation for the last month rose to a 14-month high of 7.5 per cent, and remains above the comfort zone of the Indian central bank.
The 30-stock benchmark index S&P BSE Sensex rose around 1 per cent soon after the RBI held back an anticipated rate hike.
RBI noted that headline inflation, both retail and wholesale, have increased, mainly on account of food prices. “While CPI and wholesale price index (WPI) inflation excluding food and fuel have been stable. Despite a steady and necessary increase in administered prices towards market levels, the high level of CPI inflation excluding food and fuel leaves no room for complacency. There is, however, reason to wait before determining the course of monetary policy,” it said.
RBI pointed out that there are indications that vegetable prices may be turning down sharply, although trading mark-ups could impede the full pass-through into retail inflation. In addition, the disinflationary impact of recent exchange rate stability should play out into prices. It added that the negative output gap, including the recent observed slowdown in services growth, as well as the lagged effects of effective monetary tightening since July, should help contain inflation.
RBI acknowledged that the policy decision is a close one as current inflation is ‘too high’. “However, given the wide bands of uncertainty surrounding the short term path of inflation from its high current levels, and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty,” it noted.
It said that it would be vigilant to risks including the possibility that tapering of quantitative easing by the US Fed may disrupt external markets.
“Even though the Reserve Bank maintains status quo today, it can help guide market expectations through a clearer description of its policy reaction function: if the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted, so that inflation expectations stabilise and an environment conducive to sustainable growth takes hold. The Reserve Bank’s policy action on those dates will be appropriately calibrated,” it said.
Assessment
In its monetary policy review the central bank noted that the outlook for global growth continues to remain moderate, with an uneven recovery across industrial countries. Activity in major emerging market economies (EMEs) barring China has decelerated on account of weak domestic demand, notwithstanding some improvement in export performance. While volatility in financial markets has receded, it could pick up again following the inevitable taper of quantitative easing in the US, given the large dependence of EMEs on external financing, according to RBI.
“In India, the pick-up in real GDP growth in Q2 of 2013-14, albeit modest, was driven largely by robust growth of agricultural activity, supported by an improvement in net exports. However, the weakness in industrial activity persisting into Q3, still lacklustre lead indicators of services and subdued domestic consumption demand suggest continuing headwinds to growth. Tightening government spending in Q4 to meet budget projections will add to these headwinds. In this context, the revival of stalled investment, especially in the projects cleared by the Cabinet Committee on Investment, will be critical,” it said.
The central bank also observed that retail inflation measured by the consumer price index (CPI) has risen unrelentingly through the year so far, pushed up by the unseasonal upturn in vegetable prices, double-digit housing inflation and elevated levels of inflation in the non-food and non-fuel categories.
“While vegetable prices seem to be adjusting downwards sharply in certain areas, the feed-through to much-too-high headline CPI inflation remains to be seen. Wholesale inflation has also gone up sharply from Q2 onwards, with upside pressures evident across all constituent components. High inflation at both wholesale and retail levels risks entrenching inflation expectations at unacceptably elevated levels, posing a threat to growth and financial stability. There are also signs of a resumption of high rural wage growth, suggesting second-round effects that cannot be ignored. High and persistent inflation also increases the risks of exchange rate instability,” it noted.
On the flip side, with the normalisation of exceptional monetary measures, liquidity conditions have improved, as reflected in the steady decline in the access to the MSF and capital inflows under the RBI’s swap facilities for banking capital and non-resident deposits augmented domestic liquidity significantly from the end of November.
In another positive note RBI said that the narrowing of the trade deficit since June through November, on positive export growth and contraction in both oil and non-oil imports, should bring the current account deficit (CAD) down to a more sustainable level for the year as a whole.
“Robust inflows into the swap windows opened by the Reserve Bank during August-November have contributed significantly to rebuilding foreign exchange reserves thus covering possible external financing requirements and providing stability to the foreign exchange market. Looking ahead, these favourable developments should help build resilience to external shocks,” it said.
(Edited by Joby Puthuparampil Johnson)