Yesterday’s first-quarter review by the Reserve Bank of India (RBI) was notable for three things. First, RBI narrowed the LAF corridor by 25 basis points (bps). Second, the central bank announced that it will double the number of times it reviews monetary policy during a fiscal. Third, the July statement also struck a blow for brevity in communication. All of these are welcome developments, in my view. As far as the LAF corridor is concerned, yesterday’s decision marks a shift in RBI’s thinking. Under the previous regime, RBI preferred to transmit uncertainty by maintaining a wider LAF corridor.
While there may be arguments in favour of such a stance, I believe that central banks should aim to reduce uncertainty in money markets. In other words, central banks shouldn’t depend on exogenous changes in liquidity conditions to implement monetary policy. With banking system liquidity appearing structurally short, the timing was right for RBI to narrow the LAF corridor from 150 bps. We expect this process to continue at the next policy review and the corridor to settle at 100 bps.
That review would come as early as September as RBI will now review its monetary stance eight times in a fiscal. That is in line with global best practices and would help economic agents make better informed decisions.
While some may argue that RBI will lose its ability to surprise markets, in practice, the surprise element was diminishing given the frequency with which inter-meeting rate hikes were being resorted to under the current system. There is always the concern that RBI may not have enough economic data points to take decisions every six weeks.
However, one hopes that the central bank’s decision to meet more frequently will itself spur an improvement in economic data collection and dissemination. In line with its decision to have more policy meetings, RBI has continued with the process of making its policy statements more succinct.
In the past, RBI statements have tended to be verbose and sometimes the message might have got lost. Under governor D. Subbarao, RBI has made a deliberate effort to improve the efficiency of its communication. And the loud and clear signals from yesterday’s statement are that RBI is stepping up efforts to normalize policy and that tight liquidity conditions are a part and parcel of policy normalization.
The policy stance contained a clear hint that RBI wouldn’t shrink from draining liquidity should liquidity conditions turn excess on an enduring basis. However, our base case view is that liquidity conditions will remain tight through the rest of the financial year and therefore RBI will stick to rate hikes rather than CRR hikes. Given RBI’s March inflation target of 6% (which may prove to be conservative), there is a case for the LAF corridor to straddle the expected inflation rate in order to impart credibility to RBI’s aim of anchoring inflation expectations.
We look for the LAF corridor to stand at 5.50-6.50% by March 2011. Needless to say, this view is contingent on the US and other advanced economies continuing to muddle through and not suffering from a double dip. In my view, even with global commodity prices staying range bound, Indian manufacturing prices could remain firm as domestic firms enjoy pricing power. In short, as the governor himself remarked, the RBI has its task cut out to normalize policy and gain mastery over inflation expectations.
A. Prasanna is chief economist, ICICI Securities Primary Dealership Ltd. The views expressed are his own.
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