RBI policy meeting: Reserve Bank of India looks for honourable exit

Within a span of six months, Reserve Bank of India has had to battle dual blows. The first was demonetisation which was external, though somewhat expected. The one that followed was intrinsic and less obvious to most beyond the financial markets – it’s about the central bank’s own model that is used to forecast inflation and decide on the future action on interest rates.

If demonetisation had put a question mark on the credibility of RBI, its erroneous prophesy on inflation has left the masters of monetary policy looking for ways to make a smooth and honourable course correction.

Two months ago, RBI took a hawkish note on inflation, changing its stance from ‘accommodative’ to ‘neutral’ – jargons which the rest of India may be oblivious to, but can and did sent money markets into a tizzy: if the central bank expects higher inflation, there’s little or no chance of rate cut; it’s bad news for bonds, stocks, home loan borrowers and New Delhi.

However, the retail as well as wholesale inflation rates have actually softened (instead of moving up) since RBI hardened its stand on inflation.

Forecasts, even by the best central bankers, can go haywire and models, no matter how sophisticated and precise, may fail to grasp and factor in peculiarities of an economy and fast changing realities. But when they backfire within weeks, any monetary policy authority would be in an unenviable position. That’s the situation in which Governor Urjit Patel, deputy governor Viral Acharya, and other members of the monetary policy committee today find themselves in. (Indeed, RBI watchers wouldn’t be surprised if Acharya junks the old model and picks another one to forecast inflation)

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Under the circumstances, Patel and the committee couldn’t have done anything other than what they did on Wednesday: keep interest rates and the policy stance unchanged and tell the world why they preferred a status quo. Not that they were terribly convincing. The policy statement and Acharya’s response to reporters brought to the fore an element of surprise caused by a lower inflation (which most economists believe is south-bound)

Perhaps, RBI felt crude prices would continue to climb; may be, it did not account for the positive impact of a stronger rupee and deregulation of wholesale trade in farm produce on inflation; or, it feared the monsoon could be way below normal; may be, it shouldn’t have rushed to change stance in April. Whatever the reasons are, the reality is different from what the central bank had apprehended in early April.

Nonetheless, Patel had no choice but to defend its old inflation outlook. Why? Simply because no monetary policy authority – particularly RBI whose role has been somewhat belittled by DeMo — can afford a U-turn in just two months without risking its reputation.

But Governor Patel and his team have taken the first step towards a transition. Its policy statement is dovish – perhaps a shade more than what many expected – leaving markets to bet and borrowers to believe that rate cuts could just be a matter of time. No one wants Mint Street to once again go wrong.