The Hindu Business Line : RBI’s worry on inflation continues

The hike in CRR and the tone of the policy suggests that the central bank continues to be concerned about inflation, despite the low headline wholesale price inflation numbers.

The policy document cites high food price inflation, enhanced metal prices in global markets and, of course, continuously hardening oil price as possible risks to price stability.

In fact, the rhetoric turned out to be significantly more hawkish than what had been anticipated.

The policy emphasises that a continuing surge in foreign exchange inflows could stoke inflation, both in product and asset prices. Hence, the central bank has chosen to excise some of this liquidity through increased reserve requirement.

Checking overvaluation

There are clear implications of this. The RBI’s action suggests that it would continue to intervene aggressively in the foreign exchange market to check overvaluation.

The CRR hike means that the RBI can continue to buy dollars and worry less about releasing liquidity since a larger fraction of rupee resources is being impounded by the central bank. This could help break the momentum of the rupee going forward.

Strong inflows

However, we expect inflows to remain strong and the rupee is unlikely to see a reversal in its path. In fact, the RBI, by taking this policy step, seems to acknowledge the fact that inflows will indeed remain strong and that the upward pressure on the rupee is unlikely to abate.

The risk, of course, is that if these flows are weaker than anticipated, the banking system would see a shortage of funds because of the increased reserve needs leading to an uptick in local interest rates.

This could, in turn, induce more foreign exchange flows because of the increased interest rate differential with other markets.

As far as local lending and borrowing rates go, there are no explicit signals for banks to lower rates. There are no cuts in the signal reverse repo and repo rates, for instance.

It is difficult to say at this stage whether they are likely to revise lending and borrowing sharply, but it is likely that with the hike in CRR they will take another look at their recent strategy of paring rates.

Short-term interest rates like those on commercial paper could harden on the back of a liquidity squeeze, if only temporarily.

US decision

One has to remember, however, that the Monetary Policy announcement is a relatively minor event, given that the US central bank’s rate decision will be announced tomorrow. This will determine financial market movements in the short term. The majority of market players expect a quarter percentage point-cut in the signal Fed Funds rate. Any surprises, either negative or positive, could have implications not just for asset prices but also for macro variables such as money supply and liquidity.

(The author is Chief Economist, HDFC Bank.)

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