How to restore severely dented credibility? Stick to your mission statement and redesign policy to show that institutional commitment to that mission hasn’t wavered. That in a nutshell was the Reserve Bank of India’s (RBI’s) monetary policy stance on Wednesday when it not only left policy rates unchanged against consensus expectations of a cut but also signalled an end to the rate cut cycle.
RBI’s credibility took a hard knock from a botched demonetisation exercise that purged 86% of cash by value and brought an already subdued economy to its knees. The central bank came further in the line of fire when it refused to divulge the complete data on currency notes, making it look ill-prepared for the consequences of the note ban. The institution was also seen as submissive to the government’s diktat after reports suggested the RBI board approved of the demonetisation a little too hastily.
The newly minted monetary policy committee is in the process of building a reputation that it does not answer to the whims of the government. That all the six members not only voted the second time for a pause but also gave the nod for a change in the monetary policy stance shows this.
So the central bank brought to the fore its worries on stickiness of core inflation, or inflation excluding the volatile components of food and fuel. The core hasn’t budged in over a year (the latest reading was 4.9% for December), although it did fall some between March and June 2016. Rising global crude oil prices are back to haunt the inflation outlook, the effects of the seventh pay commission’s recommendations are yet to play out and rupee depreciation could queer the inflation pitch further. While the first two arguments are solid, the rupee hasn’t weakened much. Strangely, RBI said inflation expectations still need to be checked despite the latest survey showing a massive fall in inflation expectations. The focus seems firmly back on achieving the 4% medium-term inflation target.
In all fairness, the change in stance is more than just about restoring credibility. If indeed the central bank is serious about achieving the 4% medium-term inflation target on a sustainable basis, the fear over core inflation is justified. For this, RBI is ready to pay a price as its own projection of gross value added (GVA) growth for 2017-18 is 7.4%, which is lower than GVA growth of 7.8% in FY16. This means that the demonetisation effect may stretch to even the next fiscal year, but the central bank still doesn’t feel it necessary to stimulate growth through a rate cut.
Bond traders took to heart the focus on inflation and sent yields northwards by 25 basis points. But indications of a bad bank in the offing to resolve sticky loans and a more optimistic outlook on loan growth seems to have kept rate-sensitive stocks happy, judging from the resilience of benchmark indices on Wednesday.