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Inflationary concerns remain high in RBI mid-term policy

Amit Jain

Reserve Bank of India unexpectedly raised its policy interest rate (repo rates) by 25 basis points in its mid-term monetary policy but rolled-back some of the measures it had implemented earlier to support the battered rupee currency. In his maiden monetary policy review since taking office recently, RBI Governor Dr. Raghuram Rajan increased the repo rate by 25 basis points to 7.50 percent. Economists had widely expected the RBI to leave the repo rate unchanged.

However, in a simultaneous respite to the banks, the RBI also decided to slash the marginal standing facility (MSF), the rates at which the banks borrow from RBI against securities by 75 basis points to 9.5%. This is in sharp contrast to the earlier RBI policy of raising RBI by 200 basis points. With these changes, the MSF rate and the Bank Rate are recalibrated to 200 basis points above the repo rate, at 9.5%.

It also reduced the minimum daily CRR balance that banks have to maintain to 95% of the requirement from the existing 99% requirement at present. RBI suggests that these moves will allow banks with some freedom to manage their liquidity. It has moved towards this easing, since it was warranted, given that the external environment has improved and also the fact that the government and the RBI have used the time since the measures were put in place to narrow the current account deficit and to ease its financing. This calibrated withdrawal will provide a boost to growth, reduce the financing distortions that are emerging in the market and reduce the strain on corporate and bank balance sheets. It will continue to remain vigilant about external market conditions and will do what is necessary if they deteriorate once again.

In the RBI mid-term monetary policy, while partial rollbacks of the exceptional measures were expected, the need to anchor inflationary expectations by raising the repo-rate was highlighted by Governor in the policy. It is expected that inflationary concerns would continue to remain the dominant factor driving the trajectory for repo rate going ahead. It has also announced an intention to return to normal monetary policy operations where the repo rate will return to being the effective policy rate and liquidity conditions need not be as tight as they currently are.

Another key message which was carried forward by the policy was the RBI’s aim to bring MSF rates closer to the repo rates, unlike the past few years, when the MSF rates were much higher than repo rates. The intention signalled with the same is that when the repo rate becomes the effective policy rate, and, when the exceptional liquidity measures are totally unwound, that repo rate should be consistent with the inflationary conditions in the economy.

Taking note of decision by Fed Reserve to postpone the tapering period further, the RBI policy clearly stated that it plans to use the period, which could be just a breather for some more time, to allow RBI and country create better ways to improve the balance sheet and move on growth path.

RBI has also made a reference to the rising WPI inflation rates in the country over the past three months. In this regard, it has stated that WPI inflation, which had eased in Q1 of 2013-14, has started rising again as the pass-through of fuel price increases has been compounded by the sharp depreciation of the rupee and rising international commodity prices. The negative output gap will exercise downward pressure on inflation, and the process will be aided as supply side constraints, especially relating to food and infrastructure, ease. However, it has clearly stated in the mid-term monetary policy that the current assessment is that in the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year. Touching on the CPI inflation rates, it expects robust kharif harvest to lead to some moderation in CPI inflation, even though the same may still not leave any room for satisfaction.

Amit Jain is the Editor of www.reportInsights.com, an online quarterly newsletter on corporate reporting– an initiative to improve the standards of corporate reporting in country. Amit Jain holds over 17 years experience in financial writing for "The Economic Times". He also writes tutorials for global clients on emerging stock markets and commodities in other assignments.