Much to the surprise of most economists and the markets, the Reserve Bank has hiked interest rates by 0.25 per cent. The general expectation had been that with growth flagging and inflation moderating, rates would be kept static.
However, as Governor Rajan pointed out, only the seasonal vegetable and fruit inflation have gone down. Every other inflation indicator is still very high. He also talked mostly of consumer inflation, reflecting the RBI's new found--and correct--focus on retail prices that households pay.
Most interesting was the emphasis that Rajan gave to the threat to the rupee from inflation, and that the often talked about growth-vs-inflation control choice was a false one. Here's what he said: The gravest risk to the value of the rupee is from CPI inflation which remains elevated at close to double digits, despite the anticipated disinflation in vegetable and fruit prices. Moreover, inflation excluding food and fuel has also been high, especially in respect of services, indicative of wage pressures and other second round effects. Elevated levels of inflation erode household budgets and constrict the purchasing power of consumers. This, in turn, discourages investment and weakens growth. High inflation weakens the rupee. Inflation is also a tax that is grossly inequitable, falling hardest on the very poor. It is only by bringing down inflation to a low and stable level that monetary policy can contribute to reviving consumption and investment in a sustainable way. The so-called trade-off between inflation and growth is a false trade-off in the long run.
The equity markets' reaction was interesting. As soon as the announcement came, the Sensex declined by about 225 points, going from the day's high to the day's low within seconds. However, half and hour later, they had recovered somewhat. 10-year bond yields moved up from 8.71 per cent to 8.78 over the same period, which was a reasonable reaction to the news. As with any upward surprise in interest rates, one should expect the outlook to be negative for equities and positive for fixed income investments.
In Value Research's view, Rajan is going down the right path. Controlling consumer inflation is of paramount importance. The sustained high inflation is harming savers, investments, growth, the rupee--practically every part of the economy.
However, for this crusade to succeed, the government has to do its part, of which there is little sign. When the last RBI governor had raised rates unexpectedly, Finance Minister P. Chidambaram had said in a huff that he was prepared to walk alone for growth. As it has turned out, it is now Rajan and his RBI which is walking alone on everything that matters.
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