The Hindu Business Line : RBI decouples from the Fed

Large sections of the market anticipated that the RBI would hike the reverse repo rate by 25 bps in the monetary policy. That has not happened, and rightly so. Conditions in the real economy and financial markets do not justify it.

The RBI has reached this conclusion after the detailed analysis contained in the Governor's statement. As usual, it takes in a broad sweep of domestic and global macro-economic and monetary developments and is heartened by the fact that despite oil prices touching stratospheric levels, inflation continues to be subdued and Government finances are improving.

A buoyant economy increases tax revenue and this probably accounts for the better fiscal situation. In turn, there is less need for Government borrowing and reduced stress on system liquidity.

The mop-up of around Rs 80,000 crore through Market Stablilisation Scheme (MSS) bonds has reduced the surpluses in the banking system, but not to the extent that they cannot meet credit demand or can increase interest rates.

According to the RBI, there is still Rs 1,00,000 crore sloshing around in MSS, LAF and Government account - ample enough for banks to expand credit; but it is also a warning for the central bank to be vigilant about inflation.

It is clear that even India is transforming to the new paradigm of low inflation. The experience of the last decade suggests that the onus of proof for raising interest rates is on those who think inflation is a significant risk. Witness the amazing turnaround in the Bank of England's Monetary Policy Committee where two votes to raise rates just three meetings back became four votes to drop rates. (None voted for a rise at the latest meeting). Central bankers obviously (and thankfully) can change their minds prickly. Down the road, one may see them probing the limits of monetary expansion.

Another striking aspect of the current situation is our decoupling from the actions of the US Federal Reserve, which, going by Mr Alan Greenspan's testimony to the Congress last week, is set to continue to raise rates. The short-term interest differential will narrow to 1.5 per cent and probably below.

The same thing should happen to bonds. 10-year differentials are 2.8 per cent - down from over 3 per cent but still too wide. The coming days should, therefore, see those Indian yields drift downwards to sub-7 per cent levels on 10 years. The steep curve needs some correction, given the softening inflation and its expectations. This will be in contrast to the US, where a steepening process is likely to be under way.

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