Raghuram Rajan has flunked his first major test. After huffing and puffing about inflation, he has taken the easy way out and decided to wait for more data before raising rates.
His monetary policy statement is a complete contradiction in several ways.
First, he goes hyper on inflation, leading us to believe he is going to slam the brakes. But he doesn't do that at all. He waffles. He said: "High inflation at both wholesale and retail levels risks entrenching inflation expectations at unacceptably elevated levels, posing a threat to growth and financial stability. There are also signs of a resumption of high rural wage growth, suggesting second round effects that cannot be ignored. High and persistent inflation also increases the risks of exchange rate instability."
But far from raising repo rates to indicate a determination to douse those very "inflation(ary) expectations" he instead feeds the hope that things could better if we wait a while. He sees vegetable prices falling - anyone who has lived in India knows that vegetable prices always fall in winter - and uses this to suggest that maybe, just maybe, the next bit of data will bring out better numbers and bear out his reluctance to raise rates.
This is exactly what everyone, from P Chidambaram to Kaushik Basu to Montek Singh Ahluwalia, has been urging - that inflation will come down in "unspecified" coming months. And it's never happened for over four years now.
So Rajan contradicts himself again. He says that "there is merit in waiting for more data to reduce uncertainty" but then goes on to increase the uncertainty by pointing out that "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."
Instead, he promises stronger action if he is wrong on guessing the direction of inflation. He says: "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. The Reserve Bank's policy action on those dates will be appropriately calibrated."
In short, he is merely praying that inflation falls, and promised action if things get worse.
Is Raghuran Rajan on some other planet? Elections are round the corner, and both public and private spending will accelerate through the winter and right upto summer - which will keep inflation up in several commodities.
The government is unlikely to take bold action on raising diesel prices, and subsidies are exactly where they are - heading upwards of Rs 1,20,000 crore in 2013-14, and still largely unpaid by the government.
The fiscal deficit is worse than ever - at over 84 percent as at the end of seven months.
Food inflation may ease (only in vegetables and pulses, though), but the food subsidy bill and minimum support prices are expected to rise as election season approaches. The good monsoon and expectations of a good rabi mean that fertiliser subsidies will soar.
Chidambaram can cut capital spending to meet his fiscal deficit target, but this will worsen the slowdown, and make the deficit terrible since the denominator (a lower GDP) on which the deficit is calculated will be smaller.
To shore up foreign exchange reserves, Rajan has already given banks a free lunch of $34 billion by offering a rupee swap at 3.5 percent; this has released Rs 2,10,000 crore of highly inflationary money into banks' books. This is the largest one-time money-printing exercise in Indian history. It will give a fillip to inflation unless the money is sterilised.
Rajan said: "Robust inflows into the swap windows opened by the Reserve Bank during August-November have contributed significantly to rebuilding foreign exchange reserves, thus covering possible external financing requirements and providing stability to the foreign exchange market. Looking ahead, these favourable developments should help to build resilience to external shocks."
One wonder is borrowing money at high rates to shore up the reserves is a wise move when it could be inflationary.
As for the current account deficit, it is down largely because the economy isn't growing - and oil imports are down.
India is deep into stagflation - and only serious reforms to free up the supply side and deregulation of energy prices will give it the necessary zip to start growing again.
No matter what Rajan does, the economy will slow, and it is pointless to keep interest rates low when the reason for lack of growth is not the high cost of money - it is about lack of clarity on the shape of politics in 2014.
In these circumstances, Rajan had only one thing to do: deliver a shock to the system by raising repo rates substantially - say by 0.5 percent or even 1 percent - so that the government is forced to act on its core revenue deficit. Now it won't.
By chickening out, Rajan has flunked his test. He is making the same mistake made by his predecessor D Subbarao - giving the government too much of the benefit of doubt. He has eroded his own credibility as an inflation fighter.