The Reserve Bank of India’s new governor, Raghuram Rajan, has upheld two hoary traditions of the central bank in his maiden policy statement — its commitment to combat inflation with an unequivocal focus, and its capacity to surprise the markets. Till Thursday, the expectation was that the RBI would opt for a standstill policy, especially after the U.S. Federal Reserve’s decision to postpone the tapering off of its easy money policy. But Dr. Rajan caught the market completely off-guard with his decision to raise the policy repo rate by 0.25 percentage points. The shock was immediately felt as stock market indices nosedived and the rupee lost balance. With the rate hike, the governor has signalled that there will be no change in the RBI’s primary objective of reining in inflation, even if this means that growth has to take a backseat in the interim. The policy stance is indeed pragmatic; the central bank was walking a thin line after headline inflation reared its head at 6.1 per cent in August and GDP growth fell to 4.4 per cent in the first quarter. The risk of suppressed inflation from higher energy prices undoing the beneficial impact of a bountiful monsoon was too high to be ignored. If and when the government decides to increase diesel prices, inflation is sure to go further upwards.
Dr. Rajan has balanced his approach on the rate front by loosening up a bit on the liquidity tightening measures that have been in place the last two months. The 0.75 percentage points cut in the marginal standing facility rate — the rate at which banks borrow overnight from the RBI — and the reduction in the minimum daily maintenance of the cash reserve ratio from 99 per cent to 95 per cent will help bring down the interest rate curve at the short end while releasing extra funds for banks to lend. Of course, this may not entirely satisfy banks who have been grumbling about the tight liquidity and high short-term rates. But as Dr. Rajan has pointed out, the risks for the rupee still remain as the Fed has merely postponed the inevitable. Therefore, it is not time yet to unwind the rupee supporting measures that are in place now. In fact, if the environment deteriorates again, it is quite possible that the squeeze will be back. Industry, meanwhile, is disappointed that rates have been raised and says it will affect the recovery process. However, it needs to be pointed out that what caused the slowdown were not high rates but infrastructure bottlenecks, and standstill policymaking. For the growth process to resume, these have to be corrected. And that is the preserve of the government, not the central bank, which meanwhile is continuing to do what it does best — keeping the inflationary demon in check.