India: Central Bank raises policy rate and eases exceptional liquidity measures
September 20, 2013
At its 20 September monetary policy meeting - the first meeting chaired by Raghuram Rajan - the Reserve Bank of India (RBI) raised the repurchase rate by 25 basis points to 7.50%, defying market expectations that the Bank would leave interest rates unchanged. Moreover, the Bank also decided to ease some of the measures that have been in place since July which are aimed at tightening cash conditions in order to stem the rupee's fall. Accordingly, the RBI lowered the Marginal Standing Facility (MSF) rate by 75 basis points to 9.50%. The Bank maintained the cash reserve ratio (CRR) at 4.00% as expected, but cut the daily proportion of CRR that banks must keep to 95%, down from 99%; no further change is contemplated.
According to the RBI's statement, the external environment has improved. Therefore, it's now possible for the Bank to contemplate easing the exceptional measures aimed at tightening liquidity conditions, thereby reducing volatility in the foreign exchange market. Monetary authorities also indicated that growth remains weak and is particularly sluggish in the industrial and services sectors. In addition, the Bank's decision to lift the repo interest rate comes against a backdrop of rising inflation. The Bank argued that the current assessment is that, in the absence of an appropriate monetary policy response, WPI inflation will increase faster than initially projected. The Bank added that, "what is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence."
Monetary authorities argued that, as they gradually scale back the exceptional liquidity measures, the RBI will re-assert the repurchase rate as the operative rate. Most analysts agree that the hike in the repo rate suggests that the new RBI governor's stance is moving toward inflation targeting, with an increasing role for CPI inflation, rather than WPI inflation. Moreover, analysts' view is that the MSF rate cut reflects an easing in concerns over the foreign exchange rate. Finally, private sector analysts agree that the new RBI chair is providing more clarity on instruments versus objectives, in contrast to the furtive route undertaken thus far.
The move caught the markets by surprise and thus the majority of FocusEconomics Forecast panelists are taking the recent developments into account. As a result, the panel projects an average forecast of 7.06% in the repurchase rate at the end of fiscal year 2013/14.
Author: Ricardo Aceves, Senior Economist