Decoding RBI policy: Economy can't handle such low rates

Dr Raghuram Rajan in his first policy statement has made clear his views on interest rates, inflation and the Indian rupee. He believes that the interest rates are too low given the level of inflation in the economy. He is sure that the Fed will start tapering off bond purchases sooner than later and that the INR is not out of the woods yet.

His policy moves of raising the repo rate by 25bps from levels of 7.25 percent to 7.50 percent and lowering the MSF (Marginal Standing Facility) rate by 75bps is a confirmation of his though process. The marginal roll back of daily CRR (Cash Reserve Ratio) balances maintained by banks with the RBI from 99 percent to 95 percent is more for operational flexibility rather than any liquidity easing move.

 Decoding RBI policy: Economy cant handle such low rates

Rajan in his first policy statement has made clear his views on interest rates, inflation and the Indian rupee. Reuters

Rajan's policy stance took up the yield on the benchmark ten year bond, the 7.16 percent 2023 bond, by 22bps from levels of 8.18 percent to 8.40 percent as the market reacted to the surprise repo rate hike. The Sensex and Nifty fell by over 2.5 percent, giving up a large part of its gains that was seen post the Fed policy statement on the 18th of September. The INR lost over 1 percent on worries of FII selling due to falling equity and bond prices.

The RBI wants to bring back normalcy to policy after the extraordinary policy moves that were done on the 15th of July to prevent INR volatility. Stability in global financial markets will see the RBI lowering the MSF gradually to levels of 100bps over repo. MSF was raised to 200bps over repo rate on the 15th of July. The central bank will also remove restrictions on the LAF (Liquidity Adjustment Facility) going forward and will make the repo rate the operation rate in the system.

The repo rate itself is unlikely to be brought down till such time the WPI (Wholesale Price Index) inflation and the CPI ( Consumer Price Index) inflation shows a sustained downward trend. RBI has recognized that the output gap, which is the difference between actual and potential output of an economy, is widening on the back of a weakening economy. Widening output gap lowers inflation expectations but the fact is that India faces inflation from hike in administered prices, depreciation currency and government induced rise in food prices and hence lower manufacturing inflation is negated by higher food and fuel inflation.

RBI wants to incentivize savers to save more in financial assets and the best way to go about is to keep inflation expectations low and to calibrate interest rates to levels that would induce savers to keep money in financial assets.

The question markets will ask itself now is whether RBI will raise the repo rate from levels of 7.25%. That can only be answered by Rajan on what he believes is the right level of interest rates for the economy.

Bond yields are trading at levels of 100bps to 150bps over the repo rate across the government bond yield curve. Bond yields are unlikely to rise much higher from current levels though the yield curve itself will show signs of steepening as the operational rate moves towards the repo rate.

The INR is likely to trend higher against the USD given that globally markets are short emerging currencies and the markets will cover the shorts on the back of less worries of Fed tapering.

Equity markets would stabilize and then look to trend higher, following global equity indices that are trending at record highs.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.

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Updated Date: Dec 21, 2014 00:17:45 IST