The new chief of the Indian central bank Raghuram Rajan took the market by surprise by raising key policy repo rate by 25 bps to 7.5 per cent in a hawkish attempt to fight inflation in his first monetary policy review.
In the policy review on Friday, RBI increased the repo rate or the rate at which commercial banks borrow from the central bank with immediate effect. Consequently, the reverse repo rate stands adjusted to 6.5 per cent and the bank rate stands reduced to 9.5 per cent.
RBI said in its review that the objective is to normalise the conduct and operations of monetary policy so as to allow the repo rate to resume its role as the operational policy interest rate.
It pointed out that inflation is high and household financial saving is lower than desirable, adding that as the inflationary consequences of exchange rate depreciation and suppressed inflation play out, they will offset some of the disinflationary effects of a better harvest and the negative output gap.
RBI said WPI inflation, which had eased in Q1 of 2013-14, has started rising again as the pass-through of fuel price increases has been compounded by a sharp depreciation of the rupee and rising international commodity prices.
“The negative output gap will exercise downward pressure on inflation, and the process will be aided as supply side constraints, especially relating to food and infrastructure, ease. However, the current assessment is that in the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year,” according to the policy review note.
The central bank observed that high consumer price inflation has entrenched inflation expectations at elevated levels and has been eroding consumer and business confidence. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency.
“The need to anchor inflation and inflation expectations has to be set against the fragile state of the industrial sector and urban demand. Keeping all this in view, bringing down inflation to more tolerable levels warrants raising the LAF repo rate by 25 basis points immediately,” RBI said.
Stock markets tanked after the unexpected rate hike as it increases the borrowing costs for businesses. It also sends a signal that the priority for the RBI chief is to fight inflation which has been raring to go back up with the high cost of imported fuel as also higher food priced led by onion, rather than kick-start growth.
The 30-stock benchmark S&P BSE Sensex was down 2.5 per cent in mid-day trade after the policy announcement, retracing the sharp uptick it has witnessed over the last two weeks. The index had risen almost 19 per cent between August 28 and September 19 partly by measures to support to the currency announced by Rajan earlier besides some early signs of improving economy and the US Fed’s decision not to immediately reverse monetary easing. The index recovered partly to close at 20,263.71, down 1.8 per cent.
RBI said it will closely and continuously monitor the evolving growth-inflation dynamics to act pre-emptively, as necessary. The policy stance and measures set out in this review begins the process of cautious unwinding of the exceptional measures, which will restore normalcy to financial flows.
RBI has also reduced the marginal standing facility (MSF) rate by 75 basis points from 10.25 per cent to 9.5 per cent and cut the minimum daily maintenance of the cash reserve ratio (CRR) from 99 per cent of the requirement to 95 per cent effective from the fortnight beginning September 21, 2013.
It, however, kept the CRR unchanged at 4 per cent.
RBI said it has taken a number of measures since July to tighten liquidity to dampen volatility in the foreign exchange market. These measures have raised the effective policy rate for monetary policy operations to 10.25 per cent, aligned to the re-calibrated MSF rate.
“The intent has been to maintain tight liquidity conditions at the short end of the term structure until the measures designed to alter the path of the current account deficit (CAD) and improve prospects for its stable funding take effect,” according to RBI.
It said as the external environment has improved RBI is looking to ease these measures and as a first step cut the MSF rate by 75 basis points.
In its assessment of the global and Indian economy, RBI noted that a weak recovery has been taking hold in advanced economies, with growth picking up in Japan and the UK and the euro area exiting recession. However, activity has slowed in several emerging economies, buffeted by heightened financial market turbulence on the prospect of tapering of quantitative easing (QE) in the US.
“The decision by the US Federal Reserve to hold off tapering has buoyed financial markets but tapering is inevitable,” it said.
On the domestic front, growth has weakened with continuing sluggishness in industrial activity and services. The pace of infrastructure project completion is subdued and new project starts remain muted.
The central bank observed that consumption, while relatively firm so far, is starting to weaken even in rural areas, with durable goods consumption hit hard. Consequently, growth is trailing below potential and the output gap is widening.
“Some pick-up is expected on account of the brightening prospects for agriculture due to kharif output and the upturn in exports. Also, as infrastructure investments are expedited, and as projects cleared by the Cabinet Committee on Investment come on stream, growth could pick up in the second half of the year,” it said.
Referring to the external sector and the concerns over high CAD, RBI noted that as these concerns have been mitigated after steps taken by the government, the central bank and the recent decision by the US Fed, the focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation.
(Edited by Joby Puthuparampil Johnson)