Against the current

RBI's decision not to raise rates surprises markets. Lack of a clear inflation target adds to uncertainty.

Consumer price inflation has risen to 11 per cent and the market was expecting a hike in rates, but in its monetary policy announcement, the RBI has left interest rates unchanged. Governor Raghuram Rajan indicated that inflation had risen due to vegetable prices and as core inflation had not risen, interest rates need not respond.

The RBI's policy decision came as a surprise to markets. Rajan has certainly been hawkish on inflation, but it was unlikely that his approach would pull down inflation so quickly — that is, in a period of four months — since monetary policy usually works with a lag of two to eight quarters. In the case of India, higher inflation is due to persistent and entrenched inflationary expectations. This would take time and require a period of positive real interest rates. Consequently, markets expected rates to keep going up till real interest rates reached positive territory. Since they still have not, there will be uncertainty in the market about whether the rate hike cycle has ended, or whether it is likely to continue if core inflation remains above the RBI target of 5-6 per cent. The lack of an announced CPI target has further added uncertainty to the market. Though markets would like to see the rate hike cycle end, it cannot be said that this policy clearly indicates that.

The RBI action was also reflective of what it expects aggregate demand to be. If it expected aggregate demand to rise, then it would not have expected prices to fall. The policy decision suggests that it does not expect aggregate demand to rise. This could be because of the expectation of a sharp contraction in government expenditure in an attempt to maintain the fiscal deficit target. Similarly, in his press conference, Rajan indicated that when the clearances given to stalled projects have an impact, demand might pick up. The policy decision indicates that the RBI's internal models do not expect this to happen soon. The internal assumption must suggest that demand will stay low and will not rise for another couple of quarters, by which time monetary policy contraction will have had an effect. When the RBI adopts a proper monetary policy framework, which Rajan has asked Deputy Governor Urjit Patel to work on, we can expect to see a clear inflation target and a way to get there. That should help reduce uncertainty in the market.

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