Has RBI lowered its guard on fighting inflation? It is still early days but the initial evidence suggests that the answer is ‘‘yes’’

Fourth Bi-Monthly Monetary Policy Statement, October 4, 2016

Monetary Policy                                                                                                     2016-17

The Monetary Policy Committee chose to reduce the key policy rate – the repo rate – to 6.25% from 6.5%. All six members voted in favour of a rate cut.

A key factor that plays a role in such a decision is RBI’s projected path of inflation. Here there was no change, if anything it was to the upside: 5.3% by March 2017. So then why was the change necessary?

Please see my preview to RBI’s Fourth Bi-monthly MonetaryPolicy Statement.

I appear to have been wrong on two key counts. One, I felt that Governor Patel carried the same zeal to fight inflation as his predecessor. I am not sure; perhaps time will prove me wrong.

What emerged from the statement and the media conference call is that RBI has shelved the target to hit the 4% inflation level by March 2018. On August 5, 2016, Government chose to set the 4% target – with a range of +/-2% - for the period up to March 2021. While it is the government that sets the target and the time frame, it is primarily up to the RBI to determine how to achieve it, and how soon within the time frame.

The RBI did not articulate by when it plans to hit the 4% level. The RBI’s forecast for inflation is 4.5% in 2017-18.

Two, I felt that Patel would continue with Rajan’s policy of keeping the real interest rate in the region of 1.5 to 2%; I sensed this might change but I felt the change would not happen immediately. I was wrong.

RBI has now moved to a real interest rate regime below 1.5%. The argument in favour of it by the Executive Director of RBI (Patel preferred to pass on this issue to his Executive Director to answer when asked by the media) was perhaps not convincing. In fact, for economists to whom even 0.10% is significant in macro numbers, by the RBI’s own monetary policy report calculations the real interest rate before the repo rate cut on October  was already 1.25% i.e. 6.5% one year treasury bill rate less 5.3% projected inflation by March 2017.

I believe there is now a question mark on the RBI’s credibility to fight inflation. This is certainly a more growth oriented RBI, but is there really a trade-off between growth and inflation in the long run? Rajan’s RBI did not feel so.

What does this mean for the equity market? This requires more analysis, but there might be something in this fact: post October 4, the Sensex is down, while the S&P 500 is up.