Decoder: What RBI's Raghuram Rajan is saying by keeping interest rates steady

Reserve Bank of India (RBI) Governor Raghuram Rajan acted as expected. He didn’t make any changes in key policy rates, including the repo rate, which stays at 8 percent, or the cash reserve ratio (CRR), which stays at 4 percent. However, he did make a cut in the statutory liquidity ratio (SLR) from 22.5 percent to 22 percent.

In the bi-monthly monetary announcement today (5 August), Governor Rajan gave enough indications that he is sniffing “achche din” round the corner - on growth, inflation, and government fiscal deficits - but will wait for some more time before acting on these early signals. A whiff is not enough.

Rajan’s message to Finance Minister Arun Jaitley is simple: we like what we are seeing, but we will wait to act on this information till we see more of it happening.

More from Economy

Inflation likely to be a big focus area for budget 2024, say sources Explained: Will the Bank of Japan break tradition and raise interest rates?

The significance of not changing the CRR and repo rates is that he does not want to send a premature signal of monetary easing when inflation may not be fully tamed. The meaning of the SLR cut is that if the economy revives, and the government curtails its borrowing as indicated in its budget, banks should have enough resources to lend to non-government borrowers. The RBI is creating space for greater lending to the private sector by reducing the government’s penchant for pre-empting credit.

But the broad message coming from the policy is one of caution - even though the Governor signalled that the worst may be over for the economy.

Thus, his statement, noted a revival in domestic sentiment, the easing of inflation, that the conditions are getting better for growth and exports.

The following are his key statements and what they signify.

Rajan said: Sentiment on domestic economic activity appears to be reviving, with incoming data suggesting a firming up of industrial growth and exports. The June round of the Reserve Bank’s industrial outlook survey also points to improvement in business expectations in Q2..,..there are early signs of a modest strengthening of corporate sales and business flows.

Meaning: The RBI is expecting growth this year to be better than last year, and a GDP growth of 5.5 percent looks achievable.

Rajan said: The implementation of government policy actions that have been announced should create a congenial setting for a steady improvement in domestic demand and supply conditions.

Meaning: The Governor is reasonably happy with the Union budget and government actions so far. Clearly, the Modi government and Rajan are now broadly in sync.

Rajan said: Retail inflation (as) measured by the consumer price index (CPI) has eased for the second consecutive month in June, with a broad-based moderation accompanied by deceleration in momentum. CPI inflation excluding food and fuel decelerated further, extending the decline that began in September 2013. However, with some continuing uncertainty about the path of the monsoon, it would be premature to conclude that future food inflation, and its spill-over to broader inflation, can be discounted.

Meaning: Rajan is cautiously pleased with how CPI inflation is shaping up so far, but is keeping his fingers crossed for now. He is not counting his chickens just yet.

Rajan said: The upside risks to the target of ensuring CPI inflation at or below 8 percent by January 2015 remain, although overall risks are more balanced than in June. It is, therefore, appropriate to continue maintaining a vigilant monetary policy stance as in June, while leaving the policy rate unchanged.

Meaning: Rajan does not want to make the mistake of easing up just because things are moving in the right direction. This means he will ease up in his 30 September policy only if the July, August and September CPI figures are convincingly lower.

Rajan said: Prospects for reinvigoration of growth have improved modestly. The firming up of export growth should support manufacturing and service sector activity. If the recent pick-up in industrial activity is sustained…..the central estimate of real GDP growth of 5.5 percent within a likely range of 5 to 6 percent that was set out in the April projection for 2014-15 can be sustained."

Meaning: The Governor is beginning to think “achche din” could be round the corner, but he would like to wait for more confirmatory signs.

Rajan said: In consonance with the calibrated reduction in the SLR, it is necessary to enhance liquidity in the money and debt markets so that the financial intermediation expands apace with a growing economy. In order to enable banks (for) greater participation in financial markets, the ceiling (of bonds held to maturity) is being brought down to 24 percent of NDTL (net demand and time liabilities) with effect from the fortnight beginning August 9, 2014.

Meaning: The held-to-maturity (HTM) category allows banks to hold bonds at face value even though their market value has fallen. But cutting the HTM category, banks will have to start providing for such losses. It means they have to become more active in the management of their bond holdings, and mark more of it to market. This may force banks to hold less long-dated bonds (which earn more interest) and buy more short-dated T-bills to rebalance their portfolios and lower interest-rate risks.