Raghuram Rajan dampens rate cut hopes for now. It's business as usual till next year

The problem with inflation targeting is that somehow you get bound with these numbers when contemplating policy action and it is hard to change stance, which in turn reduces flexibility. While it is debatable whether the CPI is a better measure than WPI for monetary targeting, the fact is that the RBI has pitched on retail inflation.

Can we target a price index when rate changes are unlikely to affect the components of the Index? The WPI seemed to be more amenable to monetary policy being closer to a producer index. Now that we have tied to the CPI index, which can be defended as being necessary to maintain positive real interest rates, monetary policy can be seen as a reaction to inflation rather than a cause /controller of the same.

This is where the problem starts because once you target an inflation rate; we need to specify what kind of numbers we are looking at. Next, we need a roadmap for the same which the RBI has done. Therefore, we have numbers such as 8% and 6% for the Januarys of 2015 and 2016 respectively.

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The ideological conundrum is that we cannot deviate from these numbers and have to also be convinced that when the target is achieved, then it should run along in the same direction for some time or else we have to reverse the decision on rate cuts.

The issue is complicated since in the last 10 years, only twice has the CPI inflation rate been below 6%, and in the last 8 years has exceeded this mark continuously. Curiously in the last 6 years, it has exceeded 8% in each of the years. Therefore, the 6% target is very challenging.

Against this background, the RBI policy of status quo was expected, and a rate cut was never a possibility, especially so since the RBI had mentioned in the last two weeks that even though CPI inflation had come down to less than 8% for July, it was essential to gauge whether or not it could be sustained in the coming months.

The policy also talks of the usual risks that confront any economy: global disturbances, domestic growth, exchange rate volatility, etc. There has been no deviation in stance which is a positive for the markets.

The reaction of all the markets has been fairly predictable and largely stable to the announcement or rather no announcement, the 10-Years GSec has moved upwards towards 8.5% - the slight upward movement is more due to the fact that a rate cut now looks even more distant, the rupee remains at the same level and stock indices were marginally higher from yesterday.

There are four other interesting announcements made yesterday in the policy.

While the thrust of the policy has been on talking on interest rates, there have been several measures brought in to address liquidity issues in the banking system. First the HTM (held to maturity component) is to be lowered in stages from 24% to 22%. This would actually align it eventually with the SLR which is 22%.

By correcting this anomaly, banks will be able to push through this level of roughly Rs 1.6 lakh crore of additional paper into the GSec market which will not just add liquidity to the market but also help banks take advantage of market conditions to book a profit (which happens if rates come down).

Second, the liquidity coverage ratio (LCR) has also been made more attainable for banks through this policy by changing the composition of the definition of liquid assets. At present banks are allowed to include only their excess SLR securities or those being used through the MSF window while calculating the LCR. This meant that banks which had to statutorily hold on to 22% of their NDTL as GSecs were still not allowed to use them for calculating this ratio.

This is another anomaly as the idea of having a SLR was that banks had to hold on to liquid assets which could be liquidated in times of a crisis. This was the ethos behind having this concept, which over a period of time came to be associated with the government borrowing programme and the liquidity aspects has gotten lost. By allowing 5% of this SLR to be used under the bracket of ‘high quality liquid assets’, there is respite for the banks.

Third, the policy also talks of having in place the guidelines for setting up payments banks in November. Quite clearly we are making our financial system more complex which will involve also a regulatory cost considering that these institutions will be replicating what our post offices already do.

With the government bringing in the Jan Dhan programme where banks are on a spree to sign on as many households as possible to meet targets, the payments banks concept - those which take savings but do not lend, would be competing with the commercial banks who have opened millions of such accounts already and post offices which have been doing this service for a long time now, fairly efficiently. It would be of interest to see as to how many parties would be applying for a license in this scheme.

Fourth, the RBI has also mentioned that it is working on having an early warning system created which would be parametric in nature which in turn will help the RBI to supervise them more closely. This would be an interesting model as today there are different problems face in terms of capital, quality of assets, liquidity and profitability. Having such early warning signals is always good for any financial system.

The RBI is in the wait and watch mode and would be closely monitoring the developments taking place especially on the inflation front before taking a view on interest rates. By reiterating the inflation concern, it is clear that it is a necessary condition for action and hence even growth concerns on their own will not prompt rate cut actions, which is pragmatic given our goal of having positive real interest rates. The last quarter of the fiscal year could prompt such action if the inflation picture looks good. Till then, it will be business as usual.

The author is chief economist, CARE ratings. Views are personal