If govt doesn't do its bit, Rajan's attack on inflation will hurt

The markets have reacted and impact of the policy is done and dusted. It’s time now to guess Rajan’s next move. It is very clear he will go after inflation. He had made his intent clear even in his first statement as governor on September 4, when he said the goal of the RBI is monetary stability which means low and stable inflation expectation, whether that inflation springs for demand or supply factor , from domestic or imported products.

Following from this his decision to hike the repo rate is logical. After all CPI has remained sticky at 9.5% and the wholesale inflation after bottoming at 4.8% has moved rapidly to 6.1% in just a couple of months. As the monetary policy statement reasoned: “Inflation is high and household financial saving is lower than desirable. As the inflationary consequences of exchange rate depreciation and hitherto suppressed inflation play out, they will offset some of the disinflationary effects of a better harvest and the negative output gap…Keeping all this in view, bringing down inflation to more tolerable levels warrants raising the LAF repo rate by 25 basis points immediately.”

To glean Rajan’s next step we need to understand whether he will focus on CPI or WPI. It appears he will prefer CPI. His statement dwelt more on CPI for one; sample this : “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. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency.” When I prodded him in the press conference as to whether he will watch out for CPI or WPI, he shied away from clearly admitting his bias for CPI. He said he would wait for the Urijit Patel committee report. But he gave himself away when he argued that the WPI does not have any component of services.

The decision to track CPI can mean a much more hawkish RBI that we are prepared for. Not only is headline CPI at 9.5%, non-food CPI has been sticky at 8.7%. So even assuming food inflation drops rapidly in the last quarter of 2013, headline CPI may remain well above 8%. In which case RBI may go for two more rate hikes.

Separately governor Rajan also said he wants to bring the gap between repo rate and MSF rate to one percentage point from the current two percentage points. When I asked him how much will MSF move down and how much with Repo move up to bridge the gap, he said, MSF may do more of the walking. But he did say repo has to walk up a bit. Sample this : “I don’t know, remember, we have to wait and look at economic conditions to determine what the next step will be. It can be two way, it could be that we walk more on the MSF side, but it could be that the repo rate will do some of the walking. I want to be entirely neutral on what the next step will be, it will be dependent on economic conditions.” This clearly means that repo will rise by at least 25 basis points to 7.75%.

The more important medium term questions for me is will Rajan go after inflation? will he break its back like Paul Volcker did in the US?

My sense is he won’t because he cannot. Even after one more repo hike of 25 basis points we will be at 7.75%. With a CPI of 9.5% ; a repo of 7.75% is not even hawkish. The problem for Rajan, like for all RBI governor’s is the government is not taking charge of growth. If he gets a government that clears fuel issues, works to remove mining bans, ensures discoms can buy power and charge their consumers for it, if he gets a government that hikes diesel prices and cuts subsidy, then he can go after inflation like a Volcker. FIIs will keep the faith because one arm is taking charge of growth. But if the govt doesn’t oblige, Rajan’s attack on inflation will hurt growth. In fact it could hurt so much that FIIs will flee and we will be back to the July run on the rupee. Hence perhaps the key statement of Rajan’s statement is this: “Let us remember that the postponement of tapering is only that, a postponement. We must use this time to create a bullet proof national balance sheet and growth”.

One hopes the government hears this understated plea from the new governor, asking it to do its bit. I am personally less confident.