Fourth, September 30, 2014, Bi-Monthly Monetary Policy Statement by Governor Rajan: RBI’s judgement prevails over its model

RBI Watch                                                                                    Monetary Policy 2014-15

Once again there were no surprises. Repo rate stays at 8%. No further reduction in SLR. Not a significant surprise; RBI could continue on the path of lowering SLR if there are signs of pick up in the economy.

Inflation in August trended lower to 7.8% and is below RBI’s target of 8% by January 2015. The Monetary Policy Report indicated that based on certain assumptions and current conditions, RBI’s model indicates inflation at about 7% by January 2016, well above RBI’s target of 6%. However, Rajan pointed out in the call with media that in the RBI’s judgement – so this is the subjective element – inflation is expected to reach the target of 6%, and therefore the current policy stance of the RBI is appropriate. So judgement has prevailed over RBI’s model, and rightly so, I believe. But to my mind Rajan needs to elaborate on what were the factors that influenced his judgement. This will raise the credibility of the RBI.

In this situation, RBI will resist from lowering the repo rate. This gives RBI the opportunity to attempt to keep real interest rates positive on a sustained basis.

Was the RBI’s judgement influenced by the exceptionally benign inflationary environment in the developed world? 

Following Japan, now the Eurozone is faced with the spectre of deflation – the last reading of inflation came in at about 0.5%, well below its target of 2%. So much so that one of ECB’s key rates, the deposit facility is a negative, yes negative, rate of -0.20%! This appears to have prompted the ECB to have on the front page of its website a link titled “Why has the ECB introduced a negative interest rate?” In the USA, inflation continues to be below the Fed’s comfort level also of 2%, despite strong gains in employment. Global commodity prices, including oil and gold – both critical to India’s current account deficit - are weak.

On the banking and financial structure front, Rajan announced that the final guidelines for RBI’s initiative at starting Small Banks and Payments Banks will be announced by end November, and that a new regulatory structure for Non Banking Finance Companies (NBFCs) will be introduced by end October, and this will lead to licensing of fresh NBFCs. Both are welcome and significant for the financial services sector.

To get the full context of this blog, please read the earlier one on August 21.