RBI keeps repo rate unchanged: Central bank's over-fixation on inflation in a crisis-prone economy could prove to be high-risk gamble

The star of the Friday’s monetary policy announcement was rupee, not inflation. The currency shocked the markets almost immediately after the policy announcement by testing the 74 against US dollar mark, giving its clear verdict to the financial markets that it is unhappy with the RBI’s decision not to hike rates as expected by most economists. Also, this would be remembered as a rare occasion when stocks fell sharply despite a status quo when everyone was expecting a rate hike. Equities fell, including the bank Nifty with likely heavy selling from foreign portfolio investors. This was unusual. Typically, markets react negatively if the RBI goes for a rate hike, which wasn’t the case on Friday. The policy was a disappointment on several counts. To begin with, the market was expecting a rate hike as a supportive measure to instill confidence in the currency market. This didn’t come. The sense one gets from RBI comments on rupee is that it doesn’t want to arrest the devaluation of currency using the policy tools. Perhaps, the RBI even wanted to make it clear that rupee will have to settle on its own terms. This caused panic. Similarly, beyond the rupee issue, the market was also expecting RBI to guide it on the ongoing crisis in the NBFC (Non-banking finance Company) space. Remember, the crisis triggered by IL&FS and later, DHFL, continued to impact confidence in the markets and market participants were clearly expecting the RBI to guide the system about how it plans to go about handling the crisis. But beyond a passing mention, there wasn’t any major confidence-inspiring guidance from the RBI team. One of the deputy governors hinted that the central bank is looking for more rules to address the ALM of NBFCs too spooked the markets. This led to a sharp sell-off in equity and currency markets. [caption id=“attachment_4390411” align=“alignleft” width=“380”] File image of RBI governor Urjit Patel. AFP.[/caption] The RBI’s stance in this policy is interesting. It has clearly laid out the future policy roadmap, which comprises of only two options—a status quo or rate hike. Rate cuts are off the table for now. Despite the status-quo in the policy rates, the key word in the policy document is that the central bank is now positioned towards “calibrated tightening’. This is a significant departure from the language of the last policy where the tone was largely towards a neutral stance. This might be an indication that the rate hikes may not be over and RBI is willing to go for a hike if the situation warrants. But, with the upside risks to inflation persists and in the backdrop of continuing global uncertainty and a falling rupee, a status-quo was a risky move. The lack of confidence in the currency market is something one needs to watch out for going ahead. It won’t be a surprise if rupee tests 75-mark in the near future. During the post-policy pressure, the RBI governor repeated that the central bank’s primary responsibility continues to be keeping a guard on inflation. He is right. But, the problem here is that the economy is facing nothing short of a crisis-situation with a free-falling rupee, bloodbath in equity markets and high vulnerability to external shocks mainly from the skyrocketing global crude oil prices. Also, globally central banks are on a tightening mode and India cannot take a policy stance in isolation. This was a time when the central bank needed to step in and clam the markets. But it chose to play by the rule book. Even if the RBI can assure price stability, that cannot be a solution to mounting financial instability woes in the economy. These reasons have prompted many leading economists such as HDFC Bank’s Abheek Barua to call Friday’s announcement a policy error. Nevertheless, the status quo in RBI key rates will thrill the growth lobby. Particularly, Union finance minister, Arun Jaitley has a reason to smile since yet another consecutive rate hike, and the subsequent upward pressure on the lending rates, would have weighed heavily on consumer sentiments. That would not have been an acceptable idea for the government in an election year. Going ahead, the central bank is likely to go for one or two more rate hikes in the near future. But, if the economic crisis deepens and inflation expectations go wrong, it will have to take flak for acting inadequately at a critical juncture. RBI’s over-fixation on inflation in a crisis-prone economy could prove to be a high-risk gamble.