RBI puts an end to backdoor tightening with 25 bps repo hike

In the absence of any guidance on inflation, credit growth and money supply, market expects future policy action to be reactionary

After successfully battling the currency crisis, RBI's new boss, Raghuram Rajan, has trained his guns on inflation. By bringing the spread or differential between the marginal standing facility and repo rate to 100 basis points, Rajan has put an end to the backdoor tightening route taken by his predecessor D Subbarao. With Tuesday's 25 basis point repo rate hike, RBI has ended stealth tightening and opted, instead, to officially reverse the trend of rate cuts seen during the first five months of 2013. Subbarao cut rates thrice in 2013, bringing down the repo to 7.25% with the last cut in May. From hindsight, economists are questioning Subbarao's decision to cut rates earlier in the year, as concerns on inflation were nowhere near over. Kruti Shah, economist at Karvy Stock Broking, says Rajan has taken away the feel-good picture painted by his predecessor whilst cutting rates earlier this year.

Tuesday's policy statement has put inflation back in the spotlight, as the central bank expects both retail and wholesale inflation to remain elevated through the year. Food prices, which rose 42% year on year in urban areas and 31% in rural areas, have primarily driven up the inflation print for September. With the onset of winter, vegetable prices may ease but this may not be sufficient to bring down headline rates.

For a change, economists have been actually in favour of a rate hike as real effective interest rates have been in the negative zone if one factors in high retail inflation. According to Nomura’s Sonal Varma, given the current high CPI inflation, the present repo rate has been persistently below the neutral rate, implying that monetary conditions have been too loose, so recent repo rate hikes are intended to align interest rates to "real" domestic inflationary conditions. Other economists say that with savings falling sharply, the policy statement contains little to address that. Also, the repo hikes will do little to tame inflation driven by the government's spending. The focus on cheaper consumer loans is in sharp contrast to the RBI's suggestion to banks on shoring up deposits.

What the policy fails to provide is guidance. While the policy statement expects inflation to stay elevated, it doesn’t spell out any level. Dhananjay Sinha of Emkay Global says: "The policy statement fails to provide forward looking guidance and hence, in our view is a significant dilution in terms of content and foresight. RBI has refrained from providing vital categorical projections like WPI inflation, projections on monetary aggregates such as money supply, bank deposit and credit growth." The implicit understanding is that the central bank's actions will be driven by data points as and when they emerge.