What to expect from RBI on 2nd December: If I were the Governor!

RBI Governor Raghuram Rajan is not in an enviable position ahead of 2nd December 2014 monetary policy. While he would like to stay in extended pause mode on policy rates till clarity from the FED (on shift & momentum on rate-hike cycle) and sustainability of bullish cues from external sector, there is tremendous pressure from stakeholders to cut rates now taking cues from downtrend in core, wholesale and retail inflation and the need to be seen in growth supportive mode following the footsteps of most Central Banks. The financial system has cut the deposit rates in the absence of adequate credit demand and chose not to cut lending rates with limited comfort on credit risk. The bottom-line is that while borrowers do not stand to benefit, yield on savings & investments has taken the hit.

RR has to act now on policy rates without significant impact on money market rate/yield curve to balance the stance of RBI against rest of stakeholders. There is a three point agenda now: (a) to protect the interest of retail investor community; (b) retain interest cost benefit for the systemic important borrowers in core sectors and (c) dilution of impact on Rupee exchange rate from excessive squeeze in interest rate differential to cut lumpy FII exit from Bond & equity markets.

What is the best option?

It is good to make one-time adjustment to policy rates corridor at 6.5-7.5/8.5% with 50 bps cut in Reverse Repo, Repo and MSF rates. Liquidity in the system is already in plenty to drive overnight interbank rate to around/below 7.5%, which may not be to the liking of RBI with the need to retain price stability at higher end of Repo-MSF corridor at 8.0-8.5%. This could be achieved through removal of overnight refinance from Repo counter while keeping the Repo tap open for part at 7-30 days term Repo counter and balance at MSF. The guidance on the way forward can be an extended pause till clarity from external cues (and developments) and domestic executive actions to remove supply side bottlenecks and trigger pick-up in credit demand. This will be seen win-win for all stake-holders: better inflation adjusted return for savings/investments, protect current cost advantage for borrowers and cut interest rate play on Rupee exchange rate. This action will lead to price stability in short term CP/CD money market rate at 8.5-9% across 3-12 month tenors, 10Y Gilt yield at 8.15-8.40% and USD/INR at 61-62.

If I were the Governor, I will deliver to market expectation with one-time 50 bps rate cut along with liquidity management measures to retain operating effective policy rate at 8.0-8.5% and neutral guidance on the way forward with attention on domestic and global cues that would lead to sustainability of CPI around 6% with confirmation for favourable trending into lower end of 4-8% tolerance (and comfort) zone. The need is also to moderate foreign currency inflows as RBI in $ buy mode will lead to excessive system liquidity woes with limited options for sterilisation. Is RR listening?

Moses Harding