Was Rajan Unpredictable? A comment on Rajan’s maiden monetary policy statement (MPS)

Finally, the wait is over. So also all the euphoria surrounding Rajan’s first monetary policy statement (MPS). Within two minutes of his speech, the exhalation evaporated. So what sin he committed? To anchor inflationary pressures he has raised the repo rate by 25 basis points. That implies he’s there to kill inflation, defend rupee. In a way he has impeccably taken forward the baton of fighting inflation from his predecessor. Since he has expressed concern for inflation these policy measures should not be a surprise at all! His policies imply that he is serious to raise domestic household saving, thus reducing investment on unproductive yellow metal and he shares the same pain (which poor people bear and in one of his speech Subbarao declared that he is there to represent poor people’s unspoken demands) that his predecessor felt. Rajan may be the new Paul Volcker.

Couple of things stand out from his speech are:

v  His decision to raise the repo rate by 25 basis points is based on high inflation and low household financial saving. Thus, he emphasised the later point warranties an increase in the repo rate.

v  He told the repo rate hike affects only 0.5 per cent of the entire borrowing of the banking system. Stated otherwise, it is not going constraint credit supply and liquidity. This is a very important point which has been missed in the debate and discussion on monetary policy since Governor Subbarao was habituated with rising interest rates.

v  At present interest rate is not consistent with inflation, and also inflationary expectations and suppressed inflation stemming from depreciation.

v  He was unmoved by the Fed’s decision to hold taper off. The justification he offered is that sooner than later the Fed will resume bond purchases. Once it does rupee would feel the pressure again. And suppressed inflation would unfold. Thus, it is better to be prepared by bringing down inflation till then.

v  Finally, he argued that these measures (reducing MSF rate by 75bps, raising the repo rate by 25bps to 7.50% and partial roll back of daily CRR (Cash Reserve Ratio) balances maintained by banks with the RBI from 99 percent to 95 percent) will reduce the cost of bank financing substantially while allowing us to take an appropriately precautionary stance on inflation. In his words, “we must use this time to create a bullet proof national balance sheet and growth agenda, which creates confidence in citizens and investors alike.” It is true that cost will marginally reduce since the MSF has been reduced marginally. It is also true that liquidity will also ease and credit supply would rise.

But the question is: is this enough? It seems the economy is heading towards a long winter. By drastically reducing rates now it should have revived the economy. We must remember that reduced inflation not only resulted from elevated interest rates since 2010 but also significantly from the downturn as it compressed purchasing power.

So, where did the RBI go wrong?

Core inflation is falling. As of July 2013 core inflation excluding food and fuel was 2.8% while WPI headline inflation was 5.8%. Surely CPI is much higher. Both WPI and CPI are above RBI’s comfort zone. The fact that core inflation has reduced implies that demand pressure has also dampened. It is also corroborated by falling manufacturing investment data. RBI is now eying to bring down headline inflation, especially CPI inflation.

He falls in to the trap of Subbarao’s “25 basis points doctrine”. Subbarao was much criticised for his baby-step approach to tame inflation by hiking repo rate marginally every time. It was not enough to kill inflationary expectation. This is why both inflation and inflationary expectation stay high, though responding to RBI’s call lately; with a lag of after 36 months. Given this “very slow” decline in inflation, when will inflation come to below 5%? It may take another 18-24 months, given coming state and general elections. How much cost it has inflicted to the economy?

The growth rate of money supply (M1) has fallen from 18.23% in 2009-10 to 5.85% in 2011-12. Such a drastic reduction in money supply is surely a perfect recipe for an economic disaster. The question is how long he will fight inflation and when will he ease increase rates.

Once inflation reduces to RBI’s tolerable limit, RBI will ease interest rates. Taking account of this fact, and given that very large lag of monetary policy transmission, economy is expected to remain sluggish for next 2 and half years.

Rajan said “the repo rate hike affects 0.5 per cent of the entire borrowing of the banking system”. That means he says repo rate hike does not matter much since it does not constrain credit supply and liquidity much. If he is saying that raising interest repo rate only affects less than 1% of the entire borrowing of the banking system, then why is he hiking interest rate. Anyway it won’t matter much. That means transmission policy is very weak.

Media has already reduced his status from rockstar to rock. Surely, Rajan will not be unfazed by this. But one hopes that he will be unfazed by the coming prolonged slowdown resulting from RBI’s inflation madness. Only time will tell to what extent he will be able to reduce supply-constrained inflation and at what cost.