Third Bi-Monthly Monetary Policy Statement by Governor Rajan: RBI bats once again both for lower inflation and growth

Where does the policy interest  rate go from here?

RBI Watch                                                                                    Monetary Policy 2014-15

There were no surprises. No change in the interest rate, but SLR was further reduced by 0.5% to support growth. Please see my note of June 3 after the Second Bi-Monthly statement when I wrote that I expected further reductions in SLR.

Inflation is now at or below the RBI’s January 15^, 2015 target of 8%.  It has been so for two months – June (7.5%) and July (8%).

The RBI is confident of keeping to the 8% target by January 2015, and has now set its sights –it was always there but now it is clearly in focus - on its next target of 6% by January 2016. Note, since November 2013 inflation has actually trended sharply downwards, but for two months in April and May, from 11% to 8%! Can we expect a further sharp fall in inflation to the 6% level in the next eighteen months?

Surely, just as interest rate policy had a role in reducing inflation, weak demand conditions in the economy as seen in the sharply lower growth rates - partly independent of RBI’s higher interest rate policy - in the last two years have played a role.

Now the consensus is that investment and demand will pick up in the coming months and more so into next year. The new government has started on the path of reforms, and also committed itself to getting its own house in order (fiscal consolidation). However, bottlenecks in the maintenance and growth of infrastructure will take the long term to resolve. Also, we have a whole set of structural factors inhibiting the growth of the agricultural sector – from production to storage to marketing, which will also take the long term to resolve.

This combination to my mind means that inflation, where food inflation plays a major role, is unlikely to trend sharply lower, unless growth, contrary to expectations, continues to be weak both at home and internationally. If anything, a trend up in inflation cannot be ruled out.

Hence, I do not see any change in interest rate (the repo rate) by the RBI going ahead. In fact this is necessary to enhance and heighten the RBI’s inflation fighting credibility at an entirely new level – a goal that Governor Rajan has clearly set for himself.

This also ties in with the level of real interest rates. Now, they can be considered to be positive at about 1%. RBI’s credibility as a inflation fighting central bank needs positive real interest rates – and here it does help that given the Great Recession of 2008, central banks of Europe, Japan and the USA have been forced to abandon a positive real interest rate policy for now.  However, this will need the support of the Government.

For a detailed look at monetary policy issues raised in this note, please see my note of April 16, 2014.

The lengthy post-statement conference calls with analysts and media are worth wading through. Here are some important comments by Rajan to questions.

Does the interest rate differential play a role in interest rate policy?

“My sense is that for the most part we would be driven by domestic conditions rather than external conditions in determining the interest rate. Which is precisely why we are fighting very hard to build inflation credibility, because I think once you get some inflation credibility it gives you a certain amount of flexibility in focusing on domestic conditions rather than trying to act kneejerk towards external developments.”

Inflation targeting and the use of the Taylor rule

“The first, while we have a glide path in mind, I would not say we are currently in an inflation targeting framework, but we have many of the elements in place. That said, I think we do look at what kind of policy would be consistent with a Taylor rule. But remember, Taylor rule is just an empirical statement based on behaviour of some other central banks, and we cannot be guided solely by that at this point.”

Real interest rates and monetary policy

“Real rate, if you take the deposit rate as around 9%, and you take year-on-year inflation at about 7.5% , 7.3% was last month, we are into positive real rates and these real rates are certainly on par if not better with deposit real rates across the world. So, we are getting there in terms of real rates.”

RBI’s credibility in fighting inflation

“And fourth, this I do not want to diminish, I think the expectation that we will confront and deal with inflation is much stronger now than it was earlier.”

On RBI’s target of inflation at 8% by January 2015 and 6% by January 2016

“We are confident we can get to 8%, at the current setting we are also confident we can get to 6% .”