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RBI governor Raghuram Rajan. Photo: Bloomberg
RBI governor Raghuram Rajan. Photo: Bloomberg

Monetary policy review: An unfinished business

The policy has pointed out the need to look beyond the near-term decline in inflation and refocused the goal at the medium-term target of 6% CPI by Jan 2016

The August monetary policy delivers on expected lines but is refreshing because it provides clarity on some open questions. Most important one was obviously the reaction function of Reserve Bank of India (RBI) to the recent decline in the consumer price index (CPI). It was at a 30-month low in June and close to 400 basis points (bps) down from the recent high in November 2013. Even the rather sticky core inflation has started inching down. The August policy has pointed out the need to look beyond this near-term decline in inflation and refocused the policy goal at the medium-term target of 6% CPI by January 2016. This means that the policy rate is likely to stay elevated for long, much in line with our expectations.

One basis point is one-hundredth of a percentage point.

RBI does acknowledge the recent decline in CPI inflation and mentions that the January 2015 CPI inflation target of 8% is achievable. The central bank now characterizes risks to this forecast as “more balanced", compared to “broadly balanced" in the June statement; this indicates the first target on the “glide path" is likely to be met. In fact, we expect CPI inflation to stay below 8% for the rest of FY15 with a possibility that it could slip to 6.0-6.5% by November 2014 as the favourable base effect kicks in.

However, the August policy reminds us that the job is only half-done. RBI now foresees upside risks to its medium-term CPI inflation target of 6% for January 2016. With the focus on 6% CPI by January 2016, we can infer that any base effect driven near-term respite in inflation will largely be ignored by the central bank.

Obviously, forecasting inflation so far ahead is extremely difficult in the context of CPI which is heavily influenced by volatile food prices. The fact that RBI has still chosen to remind the markets of the necessity to focus on the 6% January 2016 CPI target will increase the credibility of the inflation targeting framework. It also indicates that RBI is unlikely to make small tweaks to policy rates before then and wait for the preconditions for a proper rate-easing cycle to emerge.

There are too many unknowns to keep in mind while forecasting CPI so far ahead. Some of these are structural while some could be cyclical. RBI’s monetary policy is likely to remain a safeguard against inflation till the preconditions of a sustained disinflation process are established. For example, RBI hopes that the fiscal consolidation process will continue, reducing the pressure on aggregate demand. The focus on medium-term inflation puts the onus on the government to stick to the fiscal deficit target before the space for monetary policy easing opens up. There is also an urgent need to address bottlenecks in food supply. The smaller increase in minimum support price for FY15 is a step in the right direction but more needs to be done to ensure that the gap between wholesale and retail price of food is narrowed considerably. From a cyclical perspective, the nascent recovery in growth can pose some difficult questions to the disinflationary process as pricing power returns. It is essential to augment the supply side at a faster pace than the demand recovery and success on this front will be crucially dependent on the government’s efforts to step up investment.

RBI’s support to supply side of growth has come through more liberalized credit support to infrastructure in the recent past. The cut in the statutory liquidity ratio (SLR) by a further 50 bps to 22% is also likely to push more liquidity towards the private sector when the credit demand improves. Although this will give banks more flexibility in deploying their funds, we do not expect the SLR cut to have an immediate impact on loan growth, as banks are likely to maintain substantial excess SLR in an environment of tight liquidity. In fact, we think that some tweaking of the liquidity management framework might be needed to ensure that the call rate stays close to the repo rate. However, the SLR cut will help banks meet their liquidity coverage ratio (LCR) as prescribed under Basel III. Excess SLR contributes towards this liquidity requirement. With the SLR having been reduced by 0.5% of NDTLs (net demand and time liabilities), excess SLR in the system will rise by 43,000 crore, reducing pressure on banks to meet their LCR requirement.

Samiran Chakraborty is managing director and regional head of research South Asia at Standard Chartered Plc

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