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From growth to frying pan
Target: consumer inflation

Mumbai, Jan. 28: RBI governor Raghuram Rajan has stunned the market and confounded the pundits again by raising interest rates by 25 basis points — and then gone on to rubbish the historical debate over the conduct of monetary policy as a trade-off between inflation and growth.

“The so-called trade-off between inflation and growth is a false trade-off in the long run,” said Rajan, who has often passionately argued that inflation-targeting should form the basis for the conduct of monetary policy.

The repo rate — the rate at which the RBI lends overnight funds to banks — was raised to 8 per cent from 7.75 per cent earlier.

This is Rajan’s third rate hike since he assumed office on September 4 last year — and it’s the fourth time that he has wrong-footed the market.

The bad news was that the RBI was prepared to sacrifice growth as it strove to yank down inflation. The central bank forecast that GDP growth this year would tumble below 5 per cent. Last year, GDP growth had plunged to 5 per cent, which was the slowest since 2003.

Many had expected Rajan to stand pat on interest rates once again as he had done during the mid-quarter review last month, especially after retail inflation had tumbled below double digits in December.

But Rajan pulled the rate trigger because core consumer inflation, which strips out food and fuel components from the matrix, had remained persistently high at 8 per cent in December 2013. High core inflation is largely indicative of the rising cost of services and wage pressures, he added.

The macroeconomic and monetary development review, a document that was released for the first time along with the monetary policy rather than the day before, said that average consumer price index (CPI-combined) inflation was 9.9 per cent in the first nine months of this financial year.

Consumer inflation is projected to dip to 9 per cent by the end of March.

“Although headline inflation (which includes food and fuel) has fallen significantly with the substantial fall in vegetable prices, CPI inflation, excluding food and fuel, has remained flat and WPI inflation excluding food and fuel has risen. Given these data, the increase in the policy rate undertaken today is consistent with the guidance given in the mid-quarter review in December,” Rajan said.

However, he said there might not be an immediate need to raise rates again if inflation cooled according to the baseline projection and even raised the prospect of reversing the trajectory of interest rates.

“If inflation eases at a pace that is faster than we currently anticipate, and that reduction is expected to be sustained, the Reserve Bank will have room to become more accommodative,” he added.

The RBI governor described inflation as a “tax that is grossly inequitable, falling hardest on the very poor”. It erodes household budgets and constricts the purchasing power of consumers.

“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,” he added.

Rajan is readying to throw away the old playbook on monetary policy, which has cast the RBI governor as a tightrope artist, deftly balancing the compulsions of reining in inflation and spurring economic growth.

On Tuesday, Rajan sang the virtues of adopting the “glide path” that deputy governor Urjit Patel had recommended while outlining the framework for the conduct of monetary policy in a report submitted last week.

The suggested glide path — which casts Rajan in the role of a pilot trying to steer a wobbly plane safely down to the tarmac — has signposted inflation targets at below 8 per cent by January 2015, below 6 per cent by January 2016, before levelling out at 4 per cent.

Rajan said he had decided to raise the repo rate by 25 basis points because of the upside risk to the central forecast of 8 per cent inflation over a 12-month horizon if the policy stance remained unchanged.

“Urjit had a fantastic description. We are neither hawks nor doves. We are owls (vigilant when the others are resting). The broader point is, don’t try and put us into buckets. We are doing what is necessary for the economy,” he said while justifying the RBI’s latest action.

He added that the Urjit Patel report, which has recommended CPI inflation as a nominal anchor for the conduct of monetary policy, was being carefully examined.

Bankers, however, said they were not planning to raise their lending rates in response to the repo rate hike.


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