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Business News/ Opinion / Blogs/  Repo hike: A signal of Rajan’s lack of tolerance for inflation
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Repo hike: A signal of Rajan’s lack of tolerance for inflation

The key message from Rajan’s first monetary policy is that he will not shy away from hiking the policy rate to dampen inflationary expectations

The US Federal Reserve’s decision to hold the tapering of its bond-buying programme has given him a window of opportunity to put the house in order and Rajan has used that. Photo: Sameer Joshi/Mint (Sameer Joshi/Mint)Premium
The US Federal Reserve’s decision to hold the tapering of its bond-buying programme has given him a window of opportunity to put the house in order and Rajan has used that. Photo: Sameer Joshi/Mint
(Sameer Joshi/Mint)

The surprise element in Reserve Bank of India (RBI) governor Raghuram Rajan’s first monetary policy has been a hike in the repurchase, or repo, rate by a quarter percentage point to 7.5%. This, however, largely remains a signal as the real effective policy rate at this point is the marginal standing facility (MSF), rate which has been brought down by three quarters of a percentage point to 9.5%. In other words, banks should not be too concerned over the repo rate increase because their cost of borrowing has actually come down—from 10.25% to 9.5%.

Banks can borrow up to half a per cent of their deposit portfolio at RBI’s repo window and any borrowing in excess of that through the MSF window. Until July, the MSF rate was a percentage point higher than the repo rate. Former RBI governor D. Subbarao raised the MSF rate by two percentage points to create a three percentage-point gap between the repo rate and the MSF rate in his efforts to make short-term rates dearer. Along with this, he also tightened liquidity by limiting banks’ access to RBI funds and raising the daily maintenance of banks’ cash reserve ratio (CRR), or the portion of deposits that banks keep with RBI, from 75% to 99%. Rajan has pared it to 95% but any further reduction has been ruled out for the time being.

Since a cut in the MSF rate will pare banks’ cost of borrowing, what was the need for a hike in the repo rate? Through this hike, Rajan has sent a strong signal that he is not comfortable with the level of inflation. The wholesale price inflation rose at its fastest pace for six months in August to 6.1% and the retail inflation was 9.52%. The policy document says, “in the absence of an appropriate policy response" the wholesale inflation will be higher than the initially projected 5% over the rest of the year. What is equally worrisome is that inflation at the retail level has been high for a number of years, “entrenching inflation expectations at elevated levels and eroding consumer and business confidence".

To some extent, he has frontloaded the repo rate hike. In normal circumstances, it would have been done in December. If inflation continues to remain high, he may go for another round of repo hike by that time. The US Federal Reserve’s decision to hold the tapering of its bond-buying programme has given him a window of opportunity to put the house in order and Rajan has used that. By the time the US Fed starts cutting its $85 billion a month bond-buying programme, the repo rate might go up from this level but the transition to tight money policy will be relatively easy for the banks and their consumers as the impact on banks’ cost of borrowing will be minimal with MSF being the effective policy rate.

Ultimately, the MSF rate will be brought down from its current level of 9.5% and it will be placed at a percentage point higher than the repo rate—as it had been till July—when normalcy returns to the foreign exchange market. When that is done, the repo rate will regain its position as the effective policy rate. Will it remain at 7.5% then? Seems unlikely but even if it goes up, it will definitely be less than the current MSF rate. In other words, there will not be any dramatic impact on the banks’ cost of borrowing.

Indeed the rupee has substantially strengthened from its August level but the foreign exchange market is not normal as yet with the dollar demand of the oil marketing companies being directly met by RBI outside the market.

The key message from Rajan’s first monetary policy is pretty clear—his tolerance level for inflation is low and he will not shy away from hiking the policy rate to dampen inflationary expectations. Along with the wholesale inflation, he will keep a hawk eye on retail inflation as well. Meanwhile, the government should focus on growth by clearing projects faster and removing policy bottlenecks. RBI’s contribution to growth will be by ensuring lower inflation.

Banker’s Trust Realtime is a frequent blog by Tamal Bandyopadhyay, who writes a popular weekly column Banker’s Trust.

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Published: 20 Sep 2013, 03:30 PM IST
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