Policy watch: Read Rajan's lips

RBI might reveal its inflation expectations but not its action plan till it has an inkling of what the next government will do

The Reserve Bank of India's (RBI) policy review on Tuesday will not be business as usual even if the central bank does nothing. It would offer crucial clues about RBI's stance through the new financial year, and its long-term attitude to managing inflation and growth.

RBI is well aware the economy will run on autopilot until June, at the very least. A new government would take a while to settle in. Until there's a new finance minister and a Budget, fiscal policy will also be a matter of guesswork.

In the absence of a government, RBI has a large portfolio of responsibilities. Inflation, gross domestic product (GDP) growth, the rupee, the health of the banking sector and external debt obligations are all interwoven concerns.

Going by both actions and public statements, we know the following things. RBI believes controlling inflation (and, it is clearly placing more emphasis on consumer prices in this regard) is more important than attempting to enable GDP growth. It is prepared to take drastic and unconventional action, if it deems this necessary, to prevent a run on the rupee.

RBI has not yet had to deal with a crisis on the banking front. But it has expressed increasing concern about rising non-performing assets (NPAs); it has tried to tighten the norms regarding corporate debt restructuring, which have hit record levels. It has been forced to push back Basel-III implementation, since banks will have to raise considerable capital, which is difficult given the current state of balance sheets and sentiment. There also appears some internal concern in RBI about handing out bank licences to industrial houses.

Meanwhile, inflation has reduced at both wholesale and retail levels. The rupee has stabilised and there have been some accretion to forex reserves. However, growth has not really shown signs of rebounding and the consensus is that a rebound in GDP growth could take several quarters. Expectations are in the melting pot where inflation and the rupee are concerned. Inflation could spike if there's a poor monsoon and food prices climb as a result. It could also spike if the elections results in large quantities of unaccounted cash being pumped into the economy.

The rupee could strengthen to 55-56 against the dollar, if the foreign institutional investor (FII) money continues to flood in after elections. Alternatively, it could swing back to 64-65 if the foreign institutional investors (FIIs) start pulling out. What happens to the currency will therefore depend to some extent on election results.

The market consensus is that RBI will do nothing in this review. This is probably true. If a new government was already in charge, instead of three months into the future, the central bank might have been prepared to gamble on further dips in inflation. In the absence of a government and in the teeth of an election, likely to increase money supply, RBI is unlikely to cut rates or increase money supply. Nor is it likely to raise rates, given that inflation has eased a little.

The market, especially the financial sector, will probably lose some ground if there is a surprise rate increase. But it will be shrugged off by FIIs that are likely to remain bullish anyway. If RBI does cut rates, the current rally will become more broad- based.

What is the central bank likely to do once the 16th Lok Sabha is sworn in? In some senses, RBI's hand might be forced by the election results. If the results trigger off a big bull run, it will have to ensure the rupee doesn't appreciate in such a fashion that it impacts exports adversely. If the results trigger major FII selling, it will have to ensure the rupee doesn't plunge into free fall. There are a limited set of tools that it can use in either case to nudge the rupee back into whatever it considers the comfort zone.

On the domestic growth and inflation front, I'm guessing RBI would hold its cards close to its chest until it has an inkling of what the next government will do. But it will probably give some indication as to its inflation and growth expectations in what it says.