Stock markets are rejoicing, but why did India’s RBI keep rate hike on hold?

Reserve Bank of India (RBI) governor Raghuram Rajan gave an early Christmas gift to Indian investors on Wednesday, after the central bank decided to stay put on its policy interest rate, the repo rate, for now.

Most economists had expected the RBI to hike the repo rate by 25 basis points to 8 percent after recent data showed inflation, especially food inflation, continued to race ahead.

Markets, which had believed a rate hike was a sure thing, soared minutes after the RBI document was released. The Sensex, one of two widely watched stock market gauges, jumped 250 points to 20,865 after the RBI opted to keep the policy rate unchanged.

The repo rate is the rate which the RBI charges for short-term and overnight borrowings to the commercial banks.

Yet, apart from noting that “current inflation is too high” in its mid-quarter review of monetary policy, the RBI decided to do nothing about surging prices.

Here’s why:

One, Rajan (and practically every central banker around the world) is aware that the US Federal Reserve will be announcing a very critical monetary policy decision later today. The world is waiting impatiently to find out about whether Bernanke and team will decide to taper (pull-back) its mammoth bond-buying programme from this month or in the near future.

That is certain to keep investors on tenterhooks for most of the day; the ‘taper tantrums’ of the financial markets during the summer  (emerging market currencies and stocks tanked when everyone thought the Fed would start tapering in September) remind us of how quickly the mood can turn.

A tapering leads to lesser money being available for borrowing and investing. In theory, it leads to higher borrowing costs and fluctuations in asset returns, especially for investors who borrow in currencies that have zero or low interest rates  and invest in higher-yielding assets in emerging markets.

In August, at the height of the taper tantrum, the Indian rupee sank to nearly 70 against the dollar. It’s possible that any tapering announcement today could also lead to a negative reaction among investors, even though a small taper has already been factored into prices, according to most experts.

The RBI has probably decided that it will wait to see how the twists and turns of today’s announcement by the Fed will play out before taking any  decision on interest rates.

As the document notes: “While volatility in financial markets has receded, it could pick up again following the inevitable taper of quantitative easing in the US, given the large dependence of EMEs (emerging market economies) on external financing.” 

Two, the fact that food prices are leading the surge in inflation have also, quite possibly, led the RBI to pause before tamping down on inflation again. For one thing, there’s not much that can be achieved by an interest rate hike except ensuring that high food prices do not raise the price of manufactured goods  (in the form of higher raw material costs).

But such a rate hike only soothes the symptom (by curbing demand), and does precious little to eradicate the cause (supply bottlenecks) of the food inflation problem, as an earlier blog post notes.

In addition, Rajan expects food prices to cool in coming months. “There are indications that vegetable prices may be turning down sharply, although trading mark-ups could impede the full pass-through into retail inflation,” the RBI document states.

“In addition, the disinflationary impact of recent exchange rate stability should play out into prices.

“Finally, the negative output gap, including the recent observed slowdown in services growth, as well as the lagged effects of effective monetary tightening since July, should help contain inflation.”

Do these statements suggest the RBI is going soft on inflation? Au contraire.

As the central bank notes, “there are obvious risks to waiting for more data, including the possibility that tapering of quantitative easing by the US Fed may disrupt external markets and that the Reserve Bank may be perceived to be soft on inflation. The Reserve Bank will be vigilant

“Even though the Reserve Bank maintains status quo today, it can help guide market expectations through a clearer description of its policy reaction function: if the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted, so that inflation expectations stabilise and an environment conducive to sustainable growth takes hold,” it says.

“The Reserve Bank’s policy action on those dates will be appropriately calibrated.”

Translation: Don’t think the RBI has tapped out its monetary policy tools. It can and will hike rates later if required. And it might not wait for next month’s data and/or scheduled policy review to make that call.

It’s just waiting to see if any Fed taper announcement whips up a storm in domestic financial markets.

Overall, it’s a very smart move by Rajan to wait awhile before leaping any further to douse inflation.

So the markets can breathe easy. For now.

With a Fed announcement just hours away, the joyous reprieve may well be short-lived. Or not.

[Image Credit]

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