Hats off to Reserve Bank of India (RBI) governor D. Subbarao, for he has pulled off a near-impossible feat in his policy statement. He has managed to signal a better growth outlook and has successfully guided market expectations towards inflation risk. Achieving that combination is no major feat for any central banker.
However, doing that while assuring the bond market that RBI will facilitate liquidity conditions to manage government borrowing without crowding out private investment is the real beauty. He has managed to guide the markets towards inflation risk without upsetting the bond market, at least for now.
As widely expected, RBI kept policy rates and the cash reserve ratio (CRR) unchanged. CRR is the amount of cash, as a percentage of deposits, that banks need to keep in reserve with RBI.
RBI slightly improved its growth outlook. It now expects gross domestic product growth at “6% with upside risk” compared with “around 6%” announced in April. The upgrade to the growth outlook is encouraging as it comes despite the acknowledgment of a below-normal monsoon.
RBI raised its Wholesale Price Index (WPI) inflation forecast for end-March 2010 to “around 5%” from “around 4%” announced in April. The revised forecast still appears low, in my opinion. In order to anchor inflation expectations, RBI stated that monetary policy will continue to “condition and contain” perception of inflation in the range of 4-4.5%, in line with the medium-term inflation objective of 3%.
The overall tone of the policy statement is more hawkish than the one in April, but not as hawkish as the increase in the WPI inflation forecast might initially suggest. RBI had unexpectedly cut policy rates in April, so the less dovish tone now is understandable.
Further, RBI has hinted at a low rate regime for some time by indicating that it “…will meet the challenge of spurring private credit demand by maintaining policy rates and liquidity conditions conducive for revival of private credit demand”. Overall, the policy appears accommodative, despite the increase in the inflation forecast.
The rate easing cycle is over, in my view, and RBI appears to have signalled a shift to a neutral stance. However, liquidity conditions will remain easy and policy rates will be low for several months, which will then pave the way for rate hikes by early next calendar year. Prior to the rate hikes, RBI will begin to tighten liquidity conditions, but only after the bulk of the government borrowing programme is over.
My sense is that RBI will likely ensure that the 10-year yield remains range-bound (6.75-7.25%) in the near term. However, prospects of tightening will perhaps push it towards 7.5-8% by early-to-middle of next year. The key then will be the expectations over fiscal improvement, as a meaningful correction in the fiscal deficit could partially offset the adverse impact on tighter monetary policy.
This was Subbarao’s fourth policy statement but the first one where his actions did not go against market expectations. The policy statement was thankfully shorter than usual and clear in its message. RBI has again proved its mettle, this time under Subbarao, who has had a baptism by fire. Now, we deserve the government to deliver on its promises of fiscal improvement. Keep your fingers crossed.
Rajeev Malik is head of India and Asean economics at Macquarie Capital Securities, Singapore. The views expressed are his own.
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