It’s now official: US Federal Reserve chairman Ben Bernanke will decide on the trajectory of monetary policy in India.
In fiscal 2013, the Reserve Bank of India (RBI) cut its policy rate by 100 basis points (bps), reduced banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank, by 75 bps and also pruned banks’ compulsory bond holding by 100 bps to lift a sagging economy as the inflation threat gradually receded. One basis point is one-hundredth of a percentage point.
On top of this, it also purchased bonds worth Rs.1.5 trillion to make more money available and bring down the cost of funds.
The trend continued with a further reduction in the policy rate by 25 bps on 3 May. But things changed on 22 May when Bernanke hinted at slowing bond purchases under the so-called quantitative easing programme. That triggered the local currency’s depreciation with the flight of capital and a worldwide sell-off in bonds and equities. Subsequently, in its June mid-quarter review, RBI pressed the pause button. In July, it took a series of steps to stabilize the rupee by stamping out liquidity from the system and pushing up the cost of funds, particularly at the shorter end.
While RBI is aware of the upside risk to inflation and downside risk to growth in Asia’s third largest economy (the central bank, in fact, pared the economic growth projection for fiscal 2014 from 5.7% to 5.5%), its biggest worry now is external shocks that could stem from Bernanke’s action. At a news conference after the 19-20 June meeting, Bernanke said the Fed’s policymaking committee would likely reduce bond purchases later this year and end them by mid-2014 if job growth continues and the unemployment rate falls from 7.6% to 7%. Bernanke also tried to ease worries that the Fed would soon rein in its easy-money policies, saying at least some of them would remain in place “for the foreseeable future”. He also suggested that policymakers could maintain their current level of bond-buying if the economy falters.
But that’s no assurance for RBI. Which is why the policy stance in this review is “guided by the need for continuous vigil and preparedness to proactively respond to risks to the economy from external developments, especially those stemming from global financial markets”. In its order of priorities, what has dropped lower down the list are concern about slowing growth and inflation that could rise because of the depreciation of the local currency. Its priority No. 1 is addressing the risks to macroeconomic stability from external shocks. Risk to growth comes second and the re-emergence of inflation pressures, third. Interestingly, managing liquidity conditions to make sure that the flow of credit remains intact to the productive sectors of the economy is the central bank’s last priority. This makes it amply clear that RBI will be in no hurry to roll back the liquidity tightening, rupee-support measures although the policy has not explicitly said so. For the record, RBI said the measures will be rolled back in a calibrated manner.
Indeed, moderating wholesale price inflation, the prospects of softening of food inflation in the wake of a robust monsoon, and slowing growth would have provided a strong case for RBI continuing its monetary easing, but Bernanke’s policy of drawing the curtains on easy money has played spoilsport. A helpless RBI has urged the government to institute structural measures to bring the high current account deficit down to sustainable levels, while on its part, it is “ready to use all available instruments and measures at its command to respond proactively and swiftly to any adverse development”. The next mid-quarter review of monetary policy will be on 18 September and the second-quarter review on 29 October. We will need to watch more carefully the meetings of the Fed’s policy making body, the Federal Open Market Committee (FOMC), on 17-18 September and 29-30 October. The last FOMC meeting this year is on 17-18 December.