Two-part question

Short and long terms require different RBI actions

The Reserve Bank of India will announce its second-quarter review of monetary policy next Tuesday. This being a half-yearly announcement, it will cover domains other than monetary, so there is much anticipation about the measures that the RBI Governor, Raghuram Rajan, will announce on these. However, when it comes to monetary policy itself, the actions taken in the mid-quarter review of September 20 and a subsequent reduction of the Marginal Standing Facility (MSF) rate on October 7 have given clear indications of the RBI's short-term and medium-term monetary stance. From the short-term perspective, the focus has been to reverse the liquidity-tightening measures that were taken from mid-July onwards as a way to arrest the rupee decline. As stability returns to the currency market, the liquidity situation that prevailed before these steps should be restored. The main indicator of this is that the overnight call rate be close to the repo rate, i.e. in the middle of the Liquidity Adjustment Facility (LAF) corridor. Since July, it has been closer to the top end, represented by the MSF rate. As the MSF rate has been brought down, the call rate has come down with it, but it is still close to the top of the band.

Two steps need to be taken next Tuesday to complete the process. One, the MSF rate should be reduced so that it is 100 basis points above the repo rate (it is currently 150 bps above it). Two, the limits on individual banks' access to the repo window need to be eliminated. This should ensure desirable arbitrage between the repo window and the call market, which is a critical component of a smoothly functioning short-term money market. These two measures will help the call rate to come back to the middle of the LAF corridor.

The medium-term decision is somewhat more complicated. The repo rate was hiked by 25 bps in September, evoking some criticism from the business community and a pregnant silence from the finance ministry. But, Dr Rajan did this to assert his credentials as an inflation hawk and, having embarked on this course, it would be risky to back down now. Since then, the inflation numbers have worsened, so it would be logical to respond to this with a further hike in the repo rate. Yes, growth is showing no signs of recovery and yes, food inflation is a major reason for the reversal in the inflation trend. But, equally, a substantially lower rupee will intensify inflationary pressures in the months ahead and the lack of a policy response to higher inflation will only raise inflationary expectations. On balance, despite the certainty of howls of protest from business and perhaps even from the finance ministry, the RBI is better off reinforcing its anti-inflationary stance than diluting it or even appearing ambivalent. In short, a further 25 bps hike is warranted. Effectively, this combination of liquidity and rate actions will bring the call rate down to just above 7.75 per cent, the new repo rate. In this sense, the outcome represents an immediate loosening, just like in the mid-quarter review. But, the longer-term message will be that the RBI's response to inflation is predictable.