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RBI to keep eye on inflation

He would build on this improving environment without letting guard on the less comforting inflationary pressures.

A general assumption, given Rajan’s commitment to growth with low inflation, which is desirable for a relatively stable exchange rate, capital flows and sustained growth, is a second hike of 25 basis points in the repo rate to 7.75 per cent, given the rise in WPI rate to 6.5 per cent in September and CPI close to, if not more than, 10 per cent.

This hike in repo rate, which is designed to become the effective policy rate, will be another step to narrow the present gap with the short-term MSF (Marginal Standing Facility) rate, which had been exceptionally raised in July last to counter exchange rate volatility, and was brought down by Governor Rajan from a level of 10.25 per cent to 9 per cent in two stages, on 20 September and 7 October.

There has since been relative calm in the foreign exchange market with reduced currency volatility and the rupee has been stabilising around 61-62 to the dollar over the last two weeks. Apart from actions taken at the domestic level, the postponement of the intended tapering of asset purchases by US Federal Reserve has also helped to restore calm to markets.

The Governor had announced on September 20 that he would seek to reduce MSF rate in stages to restore normalcy in financial flows. He has already lowered it to 9 per cent while the repo rate was raised to 7.5 per cent in the mid-quarter policy review.

A similar hike in repo rate now seems not only warranted by the rise in WPI itself and inflation expectations but also by the intention to enable it to become the effective policy rate which would be consistent with inflationary conditions in the economy. These hikes would move the repo rate closer to the objective of keeping MSF and the Bank Rate only 100 basis points above the repo rate. MSF serves as the overnight interbank rate.

Rajan has gained more flexibility with a more favourable turn of developments in formulating the mid-year policy which can accelerate the process of normalization of monetary policy. His MSF rate reductions have helped to improve liquidity conditions. FIIs have returned to the equity markets. In Sep-Oct, the reserves gained seven billion dollars, reversing earlier erosions, to total 281 billion dollar on 18 October.

Meanwhile, there is a palpable sense of relief in all emerging markets with the forced delay in the Federal Reserve’s tapering of its monetary stimulus, in the aftermath of the US Government shutdown (1-16 Oct), which slowed down the American economy and job creation. This gives them time to make their own policy adjustments to cope with any spillover as and when the Federal Reserve begins to normalise the monetary policy of USA.

Lower consumer spending, some weakening in housing market, and a disappointing addition of 148,000 jobs far below expectations, in September have derailed hopes of a robust US recovery for 2013. Analysts do not, therefore, expect the Fed to begin tapering until the end of first quarter of 2014.  This looks likely given the fiscal battles still left in Congress over the 2014 budget and another possible impasse over further extension of debt ceiling which expires on 7 February.

These developments will also coincide with the succession at the head of the Federal Reserve, on 31 January, 2014 when Ms. Janet L Yellen, nominated as Chairwoman by President Obama, takes over from Mr Ben Bernanke. Ms. Yellen, 67, will be the first woman to lead the 100-year old US Federal Reserve. A long time central banker, she has been vice chairwoman of Fed since 2010.

The controversial spending cuts (sequester) enforced by the Republican majority in the House of Representatives  have dampened growth and job creation and this led to the continuation of US  unconventional monetary policy of Fed making asset purchases of 85 billion dollars a month. The earlier move to taper these purchases in the last quarter of 2013 was put off in view of low growth and high unemployment rate.

The Fed announced in September that it would begin unwinding at a future date, after clear communication of its policy, once it could see a stronger revival of economic growth and a surge in jobs which would bring down the unemployment rate. In September, the unemployment rate was still 7.2 per cent, well above the Fed benchmark of 6.5 per cent while inflation has also remained far below its 2 per cent target.

 Emerging economies including India had complained that a premature announcement of taper in May last had caused capital outflows and depreciated their currencies. The pause in tapering which should hold at least for another four or five months would enable the emerging markets to begin strengthening their domestic fundamentals and for India, the Finance Minister says all steps are being taken to neutralize any spillovers as and when the unconventional monetary policy begins to wind down.

The measures taken by RBI and the Finance Ministry have resulted in new capital inflows of around 10 billion dollars both as FII portfolio investments and increased NRI dollar deposits. Along with curbs on gold imports and narrowing of trade deficit from the second quarter (July-September), the current account deficit (CAD) is now estimated to be not more than 70 billion dollars which could be easily financed. Whatever the finance ministry’s efforts to hold down the fiscal deficit at 4.8 per cent of GDP, the economy needs policy actions to ease supply side constraints.
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