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RBI governor Raghuram Rajan has made it a habit of announcing the unexpected. Less than five per cent of economists were expecting the governor to increase interest rates, but he did, by raising repo rates by 25 basis points from 7.75 per cent to 8.0 per cent. The repo rate is that at which banks borrow money from the central bank (RBI). Thus by increasing their borrowing rates banks would either have to absorb the rate hike or pass it on to consumers.
If they absorb it, the hike would affect their margins, especially since banks are facing difficulty in raising deposits at the same rate as they are disbursing credit and thus have to rely on borrowings to bridge the gap. If however, banks pass on the hike, the move will not only be inflationary but would also result in slowing demand. This is the objective that RBI seeks to achieve through its policy announcement.
After pausing in its policy in mid-December, the RBI governor had said that he would wait for more data points to announce any monetary measures. He was expecting inflation, especially food inflation, to come down. While his wish was partially fulfilled as food inflation came down sharply, non-food inflation moved higher. The rise was on account of demand side pressure, which RBI's document points out, is due to lower finished goods and rising capacity utilisation. Rajan plans to now slow down this demand, which it expects will result in lowering of core inflation.
Rajan, like his predecessor D Subbarao, has focussed his fight on inflation. In doing so he is willing to sacrifice growth in the short term. Fiscal tightening in the third and fourth quarter is expected to bring down growth further. In fact his projection of growth for next fiscal too does not augur well for the economy. RBI expects growth to be around 5.5 per cent, which is below government expectation of over 6 per cent.
Having said that RBI's document has reasons for both bulls and bears to cheer about. Following are the statements that make up for bull and bear cases from the document.
Bull case
"...retail inflation measured by the consumer price index (CPI) declined significantly on account of the anticipated disinflation in vegetable and fruit prices.."
"..the current account deficit (CAD) for 2013-14 is expected to be below 2.5 per cent of GDP as compared with 4.8 per cent in 2012-13. The recent resumption of portfolio flows, both equity and debt, alongside the pick-up in FDI and external commercial borrowings that is underway should help finance the current account deficit comfortably."
"A pick-up in investment in an environment in which external demand continues to be supportive of export performance could impart an upside to GDP forecast."
Bear case
"...Notwithstanding the boost from stronger external demand, uncertainty continues to surround the prospects for some emerging economies, with domestic fragilities getting accentuated. Financial market contagion is a clear potential risk."
"...Consumption demand continues to weaken and lacklustre capital goods production points to stalled investment demand. Fiscal tightening through Q3 and Q4 is likely to exacerbate the weakness in aggregate demand."
"The gravest risk to the value of the rupee is from CPI inflation which remains elevated at close to double digits, despite the anticipated disinflation in vegetable and fruit prices."
"...inflation excluding food and fuel has also been high, especially in respect of services, indicative of wage pressures and other second round effects."
"If policy actions succeed in delivering the desired inflation outcome, real GDP growth can be expected to firm up from a little below 5 per cent in 2013-14 to a range of 5 to 6 per cent in 2014-15, with risks balanced around the central estimate of 5.5 per cent."
There is also a small message that Raghuram Rajan delivered to those who wanted the central bank to shift its focus from inflation to growth. This is what he has to say in favour of his fight for inflation.
"Elevated levels of inflation erode household budgets and constrict the purchasing power of consumers. This, in turn, discourages investment and weakens growth. High inflation weakens the rupee. Inflation is also a tax that is grossly inequitable, falling hardest on the very poor. It is only by bringing down inflation to a low and stable level that monetary policy can contribute to reviving consumption and investment in a sustainable way. The so-called trade-off between inflation and growth is a false trade-off in the long run."
This statement says it all, RBI will continue to fight inflation irrespective of what happens to growth. For investors waiting to choose between equity, where growth is respected and debt, where interest rates, the tool to control inflation is key, Rajan has cast his vote.
