RBI's comfort with rupee fall shows it's a flexible inflation targeter now

Every analyst and her aunt were expecting a quarter percentage point rate hike on Friday but the monetary policy committee of the Reserve Bank of India (RBI) opted to maintain the status quo.     

The stance of the policy, however, has been changed -- from "neutral" to "a calibrated tightening" -- keeping in mind the objective of achieving the medium-term target of 4 per cent retail inflation with +/- 2 per cent band. 

Contrary to widespread expectations, the Indian central bank has not hiked the rate because it sees lower inflation in the coming months. India's retail inflation dropped to a 10-month low of 3.69 per cent in August. Despite the rise in crude prices and a depreciating currency, as well as increase in minimum support prices of crops and house rent allowances of government employees, the RBI is projecting 3.9-4.5 per cent retail inflation in the second half of the financial year 2019 and 4.8 per cent in the first quarter of 2020, lower than 4.7-4.8 per cent and 5 per cent, respectively, projected in the August policy. 

This has encouraged RBI to keep the rate unchanged but it has changed the stance because there are "upside" risks to the new projections. 

Simply put, the change of stance means that from now on, the rate can move only in one direction -- upwards, even though RBI does not seem to be in a hurry for a policy rate hike. It had hiked the rate at two successive meetings in June and August, maintaining a neutral stance, which technically gives a central bank freedom to move the rate in either direction -- higher or lower.

Even after the policy announcement, the one-year overnight indexed swap, a derivative gauge where investors exchange fixed rates for floating payments, was seen pricing in three to four rate hikes in the next one year. 

After frontloading the rate hikes, the RBI is now buying time.

The three key takeaways from the October policy are:

• There will not be any dearth of liquidity in the system.
• Indeed, a rate hike can happen in future but RBI is not in a hurry. My take is, barring unforeseen developments, we may not see the next rate hike before February 2020.
• And, most importantly, marking a departure from the past, RBI has made it clear that it is not overtly worried about the level of the local currency.

At his interaction with the media after the policy, Governor Urjit Patel emphasised that the fall in the rupee is moderate compared with other emerging market currencies and what we are seeing is an exchange rate adjustment. He also spoke about the $405-billion foreign exchange reserves, which could take care of 10 months' imports. And, that RBI has no target for the rupee.

The rupee, which closed 73.85 to a dollar on Thursday, slipped past 74 after the policy announcement to touch a new low of 74.22 before retracing to 73.77, following RBI's dollar sale in the market. RBI's apparent comfort with the rupee finding its level is bound to encourage the currency punters and force the local currency down. The market will keep on testing the RBI to check on this front and a lot will depend on how the Indian central bank responds to a slipping rupee.

The bond prices rallied and the yield on 10-year bond dropped from 8.16 per cent to 8.03 per cent but it could have dropped further had there been no fall of the currency. Prices and yield of the bonds move in opposite directions.

Similarly, at the shorter end, there was a 20-25 basis point (BP) drop in money market instruments such as commercial papers and certificate of deposits. RBI's already committed Rs 360-billion infusion through the so-called open market operations in October is also playing a role in bringing down the short-term rates.  

The effect will not last for long if RBI allows a steep depreciation of the rupee. At the same time, the central bank's intervention in the foreign exchange market through dollar sale will suck out liquidity from the system.

Most financial services stocks got roasted on the bourses after the policy announcement but that had more to do with two deputy governors' talk on taking a close look at the non-banking finance companies and moral suasion to stop the practice of building long-term loan book, borrowing short.

  

Patel repeatedly emphasised the new approach of the RBI. Unlike in the past when it was expected to target multiple indicators -- inflation, rupee, growth and financial stability -- the central bank now is a flexible inflation targeter and its concern about the rupee level is limited to the extent a depreciating rupee feeds into inflation.   

That is his official stance. I would like to believe, the threat to financial stability, triggered by the near-collapse of Infrastructure Leasing & Financial Services Ltd (ILFS), India's leading infrastructure development and finance company, weighed on the MPC. There is also a tinge of worry on growth.

Look at these two paragraphs of the RBI statement: 

• However, both global and domestic financial conditions have tightened, which may dampen investment activity. Rising crude oil prices and other input costs may also drag down investment activity by denting profit margins of corporates.
• The MPC notes that global headwinds in the form of escalating trade tensions, volatile and rising oil prices, and tightening of global financial conditions pose substantial risks to the growth and inflation outlook.

At this juncture, RBI does not want to take any chance by hiking the policy rate. It would rather wait and watch for more data. However, it won't be able to keep eyes off the rupee. For the time being, the rupee takes the centrestage. 

The columnist, a consulting editor of Business Standard, is an author and adviser to Bandhan Bank Ltd