Most market analysts and observers seemed surprised by the move of the Reserve Bank of India governor, Raghuram Rajan, in raising policy interest rates, but it’s hard to see why. Inflation has been high — the recent moderation in the wholesale price index was more an aberration than a reversion to a mean — and is likely to stay that way for a host of reasons, not the least being the weakness and volatility in the rupee’s exchange rate. The other measures he announced — reducing the interest rate on the marginal standing facility at which banks can borrow from the central bank using statutory liquidity reserves as collateral, and some leeway in the average daily cash reserves that banks have to maintain — may both reduce borrowing costs for the banks, but will not help much beyond that immediately.
The reduction of the MSF rate by three quarters of a percentage point (75 basis points) is the first step in rolling back the extraordinary measures announced in mid-July when the RBI tried to arrest the depreciation of the rupee’s value against other currencies; Mr Rajan made it clear that he wants to reduce the gap between the repo rate (the RBI’s preferred policy rate) and the penal MSF rate (which had become the de facto policy rate) further, to 1 per cent. It also flattens the yield curve, which had inverted in recent months (short term rates being higher than long term rates).
But the yield curve has long been abandoned as an indicator of policy direction. Yields on the 10-year bond have fluctuated wildly enough in the past few months, rendering it rather useless as a reliable indicator. Liquidity in the overnight inter-bank market will not get better either: the gap of roughly Rs 85,000 crore plus will persist for some more time; banks’ daily borrowing by repos have averaged around Rs 48,000 crore mid-July, and about Rs 38,000 crore through the MSF. The equity, bond and currency markets fell back after rising rather quickly over the last two weeks; not by much, but enough to suggest that they may have jumped the gun too early. Mr Rajan made it amply clear that inflation was going to be his top priority, and settled the growth versus inflation question rather emphatically. Perhaps India should be thinking of ways to reverse weak investment, weak industrial output, and now falling personal consumption that go beyond just reducing interest rates. Hope from the outside world will not be forthcoming; true, the Federal Open Market Committee of the US Federal Reserve decided to continue its bond-buying program at the present level of $85 billion a month, rather than ‘tapering’. But Fed tightening is inevitable, and the sooner India readies for it, the better: the effects of another round of excessive volatility is more than the economy may be able to bear.