The August 2014 policy review was largely a non-event as far as actions go. Besides the expected status quo on monetary policy, the cut in statutory liquidity ratio and hold-to-maturity ceiling for bonds were widely anticipated by the market.

The policy assessment continues to guide expectations in all possible ways. In this context, the policy was important in two aspects. First, the dovish guidance introduced in the last policy review was dropped. Second, while RBI seemed fairly confident of achieving the January 2015 consumer-price inflation target of 8%, it has for the first time highlighted upside risks for its January 2016 CPI inflation target of 6%.

This has two ramifications. First, eager expectations of a rate cut in the near future will be tamed. Second, RBI is trying to veer myopic expectations towards the need for attaining the medium-term inflation target of 6%, instead of the fixation with the near-term target of 8%.

Market expectations are, by nature, fluid. The subtle change in RBI’s assessment has led some to believe that any easing is unlikely till the medium-term inflation target is achieved, while some others believe the failure to meet the target could bring about further tightening.

Both conclusions are strict. In fact, by an extension of this logic, no rate cut would be possible till RBI achieves the final target of 4%.

In my opinion, while RBI would continue to act as necessary to guide the economy towards sustained disinflation in a gradual manner, the medium-term target of 6% inflation will be relatively less binding vis-à-vis the near-term target of 8%. Similar would be the case with the long-term target of 4%. This will allow discretion for some monetary accommodation.

Let me elaborate. If average CPI inflation declines from 7.5-8% in FY15 to, say, 6.5-7% in FY16, RBI could still consider some discretionary monetary accommodation as repo rate, if left untouched at 8%, would start hardening real rates in the economy, hindering the recovery in growth and fiscal consolidation. This could potentially vitiate the virtuous cycle of supply-led improvement in growth-inflation balance, something which both the monetary and fiscal policymakers are trying to achieve.

Hence, for rate cuts to begin, some overshooting of inflation from its medium-term target of 6% can be accommodated by RBI, provided the outlook is benign, reasons behind the slippage stems from temporary shocks, and fiscal policy continues to consolidate with focus on improvement in quality of adjustment.

One could argue that RBI would resist using monetary accommodation and deploy credit availability and liquidity-supportive measures till the medium-term inflation target is achieved. While RBI has been adopting this strategy since April 2014, frictional stress in money markets persists and credit offtake remains lacklustre despite initial signs of a turnaround in the economy. It’s not surprising that recent term repo cutoffs have been higher and weighted average lending rates of banks (on both outstanding and fresh loans) have remained sticky despite a considerable fall in inflation. This highlights the limitation in using credit availability levers beyond a point, especially when the real cost of credit would become increasingly important.

So where does it leave us? The government has been taking steps to curb food inflation and improve business climate.

More such measures are expected in the coming quarters. As the impact of these measures starts trickling down with some lag, room for monetary accommodation would open up in April-September FY2016.

Shubhada Rao is chief economist, Yes Bank Ltd

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