Hiking, and not hiking

When the Reserve Bank of India (RBI) changed its frequency of monetary policy announcements from twice to four times a year in 2005, it was clearly motivated by the perception that the economy would benefit from "precision" handling. More frequent and, therefore, smaller changes in policy instruments would help to keep the economy more stable by both sending clearer signals to the market and posing smaller risks in the case of errors of judgment (yes, central banks are also fallible). Over the last few quarters, the macro-economic actions of the RBI have therefore been reduced to one simple question: will the reverse repo and repo rates (the rates at which it borrows from and lends money to the banking system) go up, stay the same or go down?

After some initial fuzziness, the communication between the RBI and the markets seemed to have become clear. The markets anticipated most of the interest rate moves (mostly increases). However, it must be emphasised that for most of this period, global and domestic factors were aligned in favour of higher rates. Rising global inflation, propelled by both rising energy and commodity prices and persistent GDP growth, induced most central banks to adopt anti-inflationary positions. The Indian economy found itself in pretty much the same situation and the RBI logically hiked interest rates.

This time, however, the global scenario is clearly in contrast with the domestic one. In the US, the growth cycle appears to have turned, partly in response to the steady interest rate increases carried out by the US Federal Reserve. Now the question is when, not if, interest rates will be reduced. Oil prices are softening and will be helped along by falling US consumption. If the Federal Reserve Board's actions are any indication, holding steady may have been the right thing to do for the RBI. But, India's domestic macro-economic conditions are in striking contrast; there are no signs whatsoever of a turn in the cycle. Thus, expectations about what the RBI would do were clearly divided into two camps: a hike for those who put more weight on domestic factors; status quo for those who thought otherwise.

In the event, the RBI has sought to satisfy both camps, causing some confusion in the markets in the immediate aftermath of the announcement. So far, most of the attention has been focused on the reverse repo rate, because liquidity in the banking system has been high. Tightening monetary policy would, therefore, mean making it more attractive for banks to park funds with the RBI. However, in recent months, liquidity seems to have reduced somewhat, with credit generally tending to grow somewhat faster than deposits. If that trend persists, which is probable given the current growth momentum, banks will be more likely to borrow from the RBI than to lend to it. Under these conditions, the repo rate does become operational and an increase does raise the costs of funds to banks, thereby achieving the moderating effect that the RBI intends. In short, whether this policy announcement constitutes a hike or not depends on which end of the liquidity band the banking system is in. The policy does not represent a change in direction; it simply reflects the complexity of balancing contradictory forces on the global and domestic fronts. A cop-out, some might say, but on the whole, a sensible balance.