End of tightening, new policy framework begins

Jan 29 2014, 04:06 IST
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SummaryThe RBI announced a reduction in the number of policy reviews from 8 per year to 6 per year.

Belying consensus expectation of a status quo, the RBI hiked repo rate by 25 basis points to 8.0%. Before getting into the perfunctory analysis of the motive behind the same, let me emphasize that the rate hike in my opinion is less important in the overall scheme of things.

This is because proactive management of liquidity conditions through open market operations and the term-repo window would lower the impact on money market rates. In addition, the forward guidance provided by the RBI has nearly ruled out the need for further incremental tightening. This explains why after the initial kneejerk reaction, the stock market ended nearly flat while government bond yields were actually lower by the end of the trading session.

In my opinion, January policy review will not be remembered for signaling the end of rate hike cycle that started in July 2013. It will however be remembered as an important milestone in India’s evolving monetary policy path due to a variety a reasons.

First, January 2014 policy review has kick started the process of migration to the revised monetary policy framework as outlined by the Patel Committee Report. While the recommendations are still being evaluated, the setting of the monetary policy tone with the objective of attaining 8% CPI inflation by January 2015 clearly highlights RBI’s willingness to move towards a more transparent and accountable monetary policy regime. In addition, the RBI announced a reduction in the number of policy reviews from 8 per year to 6 per year, a two-monthly cycle beginning April 2014.

Second, while headline CPI inflation is important, so is core CPI inflation. Despite the significant decline in headline CPI inflation owing to disinflationary pressures in vegetables and fruits prices, core CPI inflation continues to remain sticky at elevated levels. The rate hike by RBI is expected to curb the anticipated upside risks to core inflation emanating from increase in order books, pick-up in capacity utilisation and a decline in inventories

Third, CPI inflation going forward will gradually replace WPI inflation from a policy perspective. This is evident as RBI’s WPI inflation estimates were innocuously absent from January 2014 policy documents, a departure from the usual practice.

Fourth, the policy decision appears to have been tilted in favour of a rate hike by the recent gyrations in the global financial markets led by stress in emerging economies. The clear risk of a potential financial market contagion may have led

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