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After starting his stint with aggressive batting, RBI governor, Raghuram Rajan seems to have become cautious in his management of monetary policy. Perhaps that is the best thing to do. Volatility in the currency markets are down and so is the movement in the equity market. We are in comparatively calmer seas, which do not require jerky reactions.
Having said that we are not yet out of danger. That is the message coming out of the policy review document of the RBI. Its fight against inflation is an ongoing one. The only reason it did not increase interest rates contrary to market expectation is since RBI feels that food inflation is expected to come down soon. That might be true as kharif harvest hits the market. RBI document says that 'vegetable prices are adjusting downwards sharply in certain areas'.
Apart from this one sentence and its comment on liquidity most of the policy document is hawkish. Even as the market has reacted positively to no hike in interest rates, the reasoning and reading between the lines does not give reasons to celebrate.
Here are some of the statements from the policy documents which cries out to be cautious rather than reckless.
• '....volatility in financial markets has receded, it could pick up again following the inevitable taper of quantitative easing in the US, given the large dependence of EMEs on external financing.'
This is a lull before the next financial storm. Governments across the globe are putting up a brave face; but quantity and speed of taper can once again bring volatility in the market. Rajan has said that debt outflow in recent months have been replaced by equity inflow, any adverse news on taper can rock the boat. So is high volatility expectation by Rajan a reason to celebrate?
• '...weakness in industrial activity persisting into Q3, still lacklustre lead indicators of services and subdued domestic consumption demand suggest continuing headwinds to growth. Tightening government spending in Q4 to meet budget projections will add to these headwinds.'
RBI expects the weakness in the economy to continue. Any further increase in interest rate would badly affect the economy. Rajan is saying that Q4 will be a slow quarter as government will step on the brakes to meet it budget projections, especially on deficits. Chances are growth might be below the 5 per cent mark projected by the government. Are markets rising because of slower growth expectation by the governor?
• 'High inflation at both wholesale and retail levels risks entrenching inflation expectations at unacceptable elevated levels, posing a threat to growth and financial stability. There are also signs of a resumption of high rural wage growth, suggesting second round effects that cannot be ignored.'
High inflation is here to stay. Next round of MNREGA (Mahatma Gandhi National Rural Employment Guarantee Act) wage hikes will bring in the second round of inflation, which is not yet factored in. Falling vegetable prices will bring in only temporary relief. High Minimum Support Price (MSP) and the Food Security Bill will ensure prices remain high. This high levels of inflation leaves little room for the RBI to promote growth which will sooner than later affect financial stability in the country. Is Rajan's warning of persistent high inflation and its impact on the economy being ignored by the market?
• '...the negative output gap, including the recent observed slowdown in services growth, as well as the lagged effects of effective monetary tightening since July, should help contain inflation'
The only way inflation is likely to come down is on account of slowing demand. This in turn would mean slowing growth going forward. Is the market discounting lower inflation on account of slower growth?
RBI's policy document suggests there are more reasons to worry rather than to rejoice. Nowhere has the governor said that this is the top of the interest rate hike cycle. In fact, he has said that if the next data point is not in line with expectations, he would not hesitate to increase the rates in the interim, between two policy announcement. That only adds to the uncertainty and will make markets more volatile with every data that is released by the government.
This might be a 'well left' call by Rajan, but sooner or later he will have to hit the ball, that's the reason why he is at the crease.
