Hawkish talk, dovish walk

RBI stays the course on monetary policy

The Reserve Bank of India (RBI) has chosen to err on the side of caution, hiking key policy rates by a quarter of a percentage point each in this week’s mid-year monetary policy review. That should please the inflation hawks who have urged the central bank not to end its crusade against rising prices. The central bank acknowledged that food price inflation is no longer essentially a supply-side phenomenon outside the remit of monetary management. Instead, its very persistence suggests that it has a long-term structural dimension that is pushing up inflation expectations. This warrants the RBI’s attention as well. The central bank also seems concerned about high asset price inflation, particularly in the equity and housing markets. In fact, it complemented the rate hikes with a tightening of “micro-prudential norms” for housing loans — loan to value ratios for housing loans and risk weights for big-ticket mortgages were both increased in the policy. These measures might set a floor to housing loan rates and curb escalation in home prices. That said, policy doves do not have reason to be entirely disappointed. Despite its aggressive rhetoric on inflation, the central bank said that “the likelihood of further rate actions in the immediate future is relatively low”. A hawkish tone with dovish action is a compromise of sorts.

Central banks are known to be reticent on committing to future action and this is perhaps as good as it gets in terms of an assurance that it is headed for a pause in the interest rate cycle. Besides, the fact that this tacit commitment to pausing came with a somewhat tame forecast of 5.5 per cent for March 2011 suggests that the central bank believes that inflation is slowly coming under control. On a slightly different note, RBI pointed out that the nominal appreciation of the rupee might not have the kind of adverse impact on competitiveness that some analysts fear. Using the broad-based 36-currency real effective exchange rate (REER), RBI pointed out that the rupee’s real appreciation in 2010-11 against this basket of currencies was a minuscule 0.4 per cent. This reflects the fact that many of our competitor currencies have also seen significant appreciation at the time that the rupee is appreciated. If RBI is indeed basing its exchange rate policy on this notion of competitiveness, then it might not necessarily intervene in the foreign exchange markets even if the rupee were to gain more against the dollar. Thus, RBI seems to have found its own way out of the so-called “messy trilemma” of managing persistent inflation, an apparently wayward exchange rate and an embarrassment of riches in terms of capital inflows.

Finally, Wednesday’s monetary policy announcement by the US Fed is expected to impact Indian equities more than Tuesday’s monetary policy statement by RBI — a sign of who is shaping market expectations. Indeed, more than policy rates, it is the new directions on financial sector policy outlined in the governor’s statement, especially new directions on housing loans and on prudential norms for financial conglomerates, that are likely to matter more for the Indian banking sector. In walking the talk on this front, RBI has reassured all that it is second to none when it comes to ensuring financial stability and prudential regulation.