Key messages in Rajan's last policy

On the surface, the third bi-monthly monetary policy statement for 2016-17 announced on Tuesday is not particularly unusual. There is no change in the policy repo rate and the Cash Reserve Ratio, or CRR, which stand at 6.5 per cent and 4 per cent respectively. And unsurprisingly, there is market acceptance that this is what is required for our times.

Without engaging in any rhetoric, keeping steady course and signing off with a policy that reiterates, in fact reinforces the policy stance that has been the hallmark of his tenure, the Governor has replied with force and vigour.  What the policy is saying without saying it in as many words is that there was no way that rates could have been lower than were offered during the last three years and that any other course would have been perilous.  That we are poised the way we are as an economy with a sharper-than-anticipated increase in food prices tells its own tale of the risks posed by inflation.

Without engaging in any rhetoric, keeping steady course and signing off with a policy that reiterates, in fact reinforces the policy stance that has been the hallmark of his tenure, the Governor has replied with force and vigour.  

To that extent, the policy stands out as a unique document in terms of macroeconomic developments, liquidity management, pass-through of past policy repo rate cuts to lending rates and more importantly the linkages between corporate sector credit demand and business, and public sector bank balance sheets.

Read in conjunction with the opening statement of the Governor at the post-policy news conference, the message emerges loud and clear. In fact, the opening statement is quite uncharacteristic of RBI statements and states the position rather bluntly.

Despite easy liquidity, rate cuts have been passed by banks only modestly. First, says the Governor, it was a liquidity issue. When that was addressed, it became the coming Foreign Currency Non Resident, or FCNR (B), redemptions that was the reason for not cutting rates, and he adds: “I have a suspicion that some new concern will crop up once the FCNR(B) redemptions are behind us.”

These are strong words with the message that at the heart of the issue is not liquidity or interest rates; other measures are required rather than a rate cut that is being peddled as a panacea for pushing credit. At the end of the day, both corporate sector and public sector banks should focus on correcting their respective balance sheets. This could help improve credit demand pick up by the corporate sector and augment the growth trajectory.

This is a message that the government, businesses, banks and the new Governor who will replace Dr. Rajan should not miss. A rate cut offered merely as a sugar pill to inject short term energy without addressing the underlying issues at stake will only bring what it can – short term energy at the cost of long term health of the economy. 

Giving in to these cries for candy is precisely what a Governor should not do, and full marks must be offered to Dr. Rajan for keeping to the path. In not giving in, he has laid down a principle that can add to the wealth and strength of the RBI as an institution that will work for the larger good. 

As the former RBI Governor Dr. Duvvuri Subbarao said only last week in an interview on “Who Moved My Interest Rate?, his book on the RBI, “Price stability is at the heart of a Central Bank’s mandate.”  

Dr.Rajan’s last policy of the tenure comes at a time the economy is giving us mixed signals. There remain concerns on the global economic outlook and the “fragile” near time outlook for emerging market economies due to policy uncertainties and soft commodity prices.

There are silver linings on the domestic front. These include the gathering pace of the South West monsoon (more than 80 per cent of the country has received normal to excess rainfall), signs of improvements in industrial production and services sector. Accordingly, the RBI has retained the growth projection for 2016-17 at 7.6 per cent with the assessment that risks facing the economy at this juncture are evenly balanced around it.

However, when it comes to inflation, we are not in a comfortable zone yet. As the policy document points out, retail inflation measured by the headline Consumer Price Index (CPI) rose to a 22-month high in June, a sharp spike on account of food with higher vegetable prices, firming up of sugar prices and the rise yet again of the prices of pulses.  At the same time, services inflation remains “sticky”.

The RBI has some optimism on food inflation given the progress of the monsoons but there remain concerns on inflation excluding food and fuel. The full implementation of the recommendations of the seventh Central Pay Commission on allowances will affect the magnitude of the direct effect of house rents on the CPI, which can push up inflation. Nevertheless, on balance, the RBI has kept its earlier projections of 5 per cent for 2016-17 with risks of some upward movement.

Going forward, the monetary policy will be accommodative to the market conditions by maintaining neutral liquidity. The RBI will use the Open Market Operations purchase/sale for handling durable liquidity mismatches and the policy repo rate and reverse repo rate to manage any transient mismatches.

In sum, Dr.Rajan’s was an important tenure that saw some institutional transformation with a switch to inflation targeting, taking headline CPI as the target inflation. He can claim success in controlling inflation and anchoring inflation expectations despite food inflation raising its ugly head ever so often.  This will also be the last meeting with a Governor fixing the policy. We will soon have a Committee which can bring several other perspectives to the table.

Dr. Rajan has left behind him for his successor a disinflationary glide path, an inflation targeting monetary policy framework and above all the eternal philosophy of central bank independence. The new governor will have the challenging task.

(Dr. R K Pattnaik is Professor, SPJIMR. Jagdish Rattanani is Editor, SPJIMR. Views are personal)