The markets may not have quite appreciated it, but the Reserve Bank of India’s monetary policy committee (MPC) has done the right thing by not raising its short-term lending or “repo” rate. By retaining the benchmark rate at 6.5 per cent, even while explicitly declaring a change in its monetary policy stance from “neutral” to “calibrated tightening”, the MPC has addressed concerns relating both to inflationary pressures and shortage of liquidity in the system.
Markets detest uncertainty. They expected a minimum 0.25 per cent increase in the repo rate — partly as a response to growing inflation and fiscal risks from global crude prices crossing the $ 85/barrel mark, and also as a tool to defend the rupee by preventing further capital outflows. When that did not happen, it left the street disappointed: The BSE Sensex, which had already fallen nearly 317 points before the MPC’s unexpected pause announcement came, shed another 476 points to end the day at 34,377. The rupee, too, closed at a fresh all-time-low of 73.77-to-the-dollar, having touched 74.21 at one point.
There is no doubt that rising fuel prices — and the chances of their going up further, given reduced crude supplies due to US sanctions on Iran and the usual winter-time demand increase — pose significant cost-push inflation risks to the economy today. A mounting crude oil import bill, moreover, could cause a further widening of India’s external current account deficit and a weakening of the rupee, thereby adding to inflationary pressures. If the Centre and state governments were to cut excise duties/value added tax rates on diesel and petrol — as was seen on Thursday and may be seen more as elections approach — the strain on public finances would bring back memories of the “twin deficits” (fiscal and current account) that characterised the last years of the UPA regime. In such times, the markets always look upon the central bank as a beacon of macroeconomic stability.
There is nothing in the MPC’s latest bi-monthly policy statement, though, to suggest a lowering of guard vis-à-vis inflation. Consumer price inflation in July and August, at 4.2 per cent and 3.7 per cent, respectively, was lower than the 4.6 per cent average that the MPC had projected for the July-September quarter. If despite that, the monetary policy stance has been changed to “calibrated tightening”, it reinforces the commitment of the central bank to achieving the objective of targeting inflation at 4 per cent within a +/- 2 per cent band.
Hiking interest rates in order to defend the rupee is a bad idea. It is even more so in the current scenario of a liquidity squeeze, following the defaults by IL&FS and the resulting drying up of credit to non-banking financial companies. Close vigil on inflation and calibrated tightening, not interest rate volatility, is what the economy needs today.