The most important part of the Reserve Bank of India’s (RBI) first mid-quarter monetary policy review was the following statement by RBI: “The tightening that has been carried out over this period has taken the monetary situation close to normal. Consequently, the role of normalisation as a motivation for further actions is likely to be less important. Current and expected macroeconomic conditions will be the more important considerations going forward." RBI is saying here that the policy mode so far had been one of normalization of the policy rate from the very low levels to which it had been pushed as a result of the financial crisis. It further believes that interest rates and other monetary conditions are now “close to normal" and future policy decisions will, therefore, be dependent on the data. In short, if inflation is lower and lending rates are higher or if growth has moderated a bit at the time of the next policy review, or if external conditions do not look up, RBI is saying there won’t be any need for further rate hikes.

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But are these conditions likely to be met? Will the data support a pause in rate hikes? RBI has said that inflation has reached a plateau and will remain “unacceptably" high for some months and there’s a “need for continued policy response to contain inflation and anchor inflationary expectation".

Moreover, the statement also says the policy tightening has been motivated by the need to end negative real interest rates, which have been rising because of policy action in raising rates, on the one hand, and declining inflation, on the other. It adds: “Both factors are at work, but the process is still incomplete". In other words, the statement seems to be saying that while the next course of action will be data-dependent, RBI at the moment doesn’t believe that it has done enough. More importantly, we need to look out for a lower level of inflation and for real deposit rates to become positive for the central bank to pause.

Speculation has already started, though, about whether RBI will hike rates at its next policy review meeting in November. As of now, inflation is on a downward trajectory, while the Purchasing Managers’ Index (PMI) data show a moderation in the momentum of growth. But we do have the festival season between now and then, which would mean growth should remain strong at the time. That could also mean some upward pressure on non-food manufacturing inflation.

But if we look at real interest rates, wholesale price-based inflation is expected to be around 6% or even lower by the end of the current fiscal. Since the real interest rate is the current rate less expected inflation and not current inflation, the real policy rate is no longer in negative territory.

That’s true for deposit rates as well, though it could be argued that RBI wants real deposit rates to go even higher, to ensure stronger growth in bank deposits.

Nevertheless, some are already calling for a pause in rate hikes. If the current moderation in both inflation and growth continues, even if RBI does raise its repo rate by another 25 basis points in its November review meeting, it will very likely have done with hiking rates for the year.

RBI has also clearly said it expects current tight liquidity conditions to prevail, maintaining the repo rate as the effective policy rate and leading to better transmission of its policy stance. Nevertheless, it has also hiked the reverse repo rate by a more than expected 50 basis points, just in case liquidity increases. It’s very likely that RBI will take steps to ensure that the repo rate remains the operative rate, by tightening liquidity if need be.

Banks are already in a tight position. The latest RBI data show that while deposit growth is 14.4% year-on-year, growth in bank credit is 19.4%. That has led banks to raise deposit rates. It has had some effect, and term deposits with banks, which were stagnating, have started to pick up in the last couple of months. That, together with lower credit growth, has led to banks’ credit-deposit ratio coming down from 73.3 in mid-June to 71.8 by 27 August. But the lull in bank credit growth is likely to be temporary and, as the busy season gets going, the tight liquidity situation with banks may force them to hike deposit and lending rates without further assistance from RBI.

The markets should take comfort from RBI’s clear enunciation that its policy in future will depend on the data. It has also clearly stated that inflation and real interest rates will be the numbers to watch out for. That will make monetary policy less uncertain, going ahead. The statement that rates have now come back to normal, with the implication that RBI will be less of a hawk on raising rates, is also positive for the markets. On Thursday, since the 25 basis points hike in the repo rate was entirely on expected lines, banks and realty stocks rose in a weak market.

But as the chart shows, the repo rate was at 6% in April 2005 in the middle of the last cycle. Within the next two years, it went up to 7.75%. The fact that we may be near a pause in tightening so early in the current recovery is an indication how different conditions are from a normal cycle.

Graphic by Yogesh Kumar/Mint

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