Rajan sends goodwill card to Modi and Jaitley, shifts policy stance to neutral

One thing Reserve Bank Governor Raghuram Rajan and Prime Minister Narendra Modi share is their ability to surprise us. They both seem to set great store by it.

In his bimonthly monetary policy statement, Rajan was widely expected to do nothing on rates. He hasn’t, but that has not stopped him from sending his own message of peace and goodwill to the new government even without formally backtracking on his anti-inflationary stance.

He has sent an indirect message on inflation by reducing the statutory liquidity ratio (SLR) by half a percent to 22.5 percent and reducing the liquidity provided under export credit refinance (ECR) from 50 percent of export outstandings to 32 percent (while compensating for this through a special term repo). These are friendly messages couched in monetary verbiage.

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First, he is willing to give the government some breathing space to get its fiscal consolidation and supply-side actions in place to reduce inflation. He is thus shifting his monetary stance from aggressively anti-inflation to neutral, as evidenced in this statement. “The risks to the central forecast of 8 percent CPI inflation by January 2015 remain broadly balanced. Upside risks in the form of a sub-normal/delayed monsoon on account of possible El Nino effects, geopolitical tensions and their impact on fuel prices, and uncertainties surrounding the setting of administered prices appear at this stage to be balanced by the possibility of stronger government action on food supply and better fiscal consolidation as well as the pass-through of recent exchange rate appreciation.” The key word is clearly balance - which means the RBI is seeing both growth and inflation as key challenges, and not excessively focused only on inflation. By “pass-through of exchange rate appreciation” he means this will reduce commodity inflation as imported fuel will now be cheaper in rupee terms.

Second, Rajan is also sending a veiled message to government that it should not expect cheap loans just because liquidity is easier due to dollar inflows. This he has done by reducing the SLR - the amount banks need to invest in government securities - by half a percentage point. While this will have no immediate impact on banks’ investments in government securities (it is now well over the 23 percent limit), the signal is that private lending will revive and government needs to create space for it. This will keep borrowing rates for government steady instead of heading downwards. However, banks nursing lots of bad loans will not be eager to reduce their government bond holdings till they see an improvement in their loan books. So Rajan is gently advising government not to borrow too much, and avoid crowding out private borrowing as the economy revives.

Third, in order to keep the rupee from appreciating too much, the RBI is increasing the amount of cash Indians can remit abroad from $75,000 to $125,000. This will enable some of them to buy real estate and property abroad. It will also ease some of the pressure resulting from dollar inflows, which are making the rupee stronger and exports tougher. Once again, the RBI is weighing in on the side of growth. A pure anti-inflationary stance would have been to let the rupee rise, thus reducing imported inflation. But he is trying to back export growth by keeping the rupee on a leash.

But by far the biggest message Rajan is sending the Modi government is that he is willing to play ball by giving it space to prove it can act on the fiscal side.

The key statement to read in the monetary policy note is this: “The Reserve Bank remains committed to keeping the economy on a disinflationary course, taking CPI inflation to 8 percent by January 2015 and 6 percent by January 2016. If the economy stays on this course, further policy tightening will not be warranted. On the other hand, if disinflation, adjusting for base effects, is faster than currently anticipated, it will provide headroom for an easing of the policy stance.” (Italics mine)

Translated, it means the Reserve Bank is not abandoning its watch on inflation, but it wants to give the new government time to get its act together and challenging it to give the central bank a reason to cut rates. This is what it means when it says that if inflation sticks to its course, “further policy tightening will not be warranted”. And, if there is any good news on the inflation front, it will be eager to cut rates. So Rajan says that “if disinflation… is faster that currently anticipated, it will provide headroom for an easing of policy stance.”

Rajan is willing to meet Modi and Arun Jaitley half-way on growth.