Finance Minister P Chidambaram might have to walk alone for some more time at least.
In his maiden monetary policy decision, Reserve Bank of India (RBI) Governor Raghuram Rajan surprised the markets - in euphoric mood on Thursday after the US Federal Reserve postponed plans to cut the asset-purchase programme - by raising interest rates for the first time in nearly two years, to ward off rising inflation.
RBI, however, scaled back some of the emergency measures put in place to support the struggling rupee, bringing down the cost of funds for banks.
In his post-policy media briefing on Friday, Rajan set the tone by saying: "The postponement of tapering is only that, a postponement. We must use this time to put our house in order, to create a bulletproof national balance sheet."
This comment drew applause from some quarters. "Rajan has established his credentials as a responsible central banker … who is not a cavalier cheerleader for growth," said Abheek Barua, chief economist, HDFC Bank.
RBI increased the repo rate by 25 basis points (bps) to 7.50 per cent, defying widespread forecasts that Rajan would leave the rate on hold to bolster a sluggish economy. The governor said domestic drivers of the rupee would now take precedence: "The focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation."
The finance ministry did not give a comment on the monetary policy, a rarity.
Finance Minister P Chidambaram had in October 2012 said the government would "walk alone", if required, to face the challenge of growth, after former RBI governor D Subbarao did not change the key policy rate in the monetary policy review then. The government had earlier unveiled a fiscal consolidation road map to give a push for growth. But Subbarao decided rising inflation was a priority over growth push.
The RBI governor said, "In the absence of an appropriate policy response, WPI (Wholesale Price Index-based) inflation will be higher than initially projected over the rest of the year. What is equally worrisome is that inflation at the retail level, measured by the CPI (Consumer Price Index), has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence."
Observers said this clearly meant the central bank wanted the finance ministry to take action to reduce the fiscal deficit and curb inflation.
While partially scaling back the average Cash Reserve Ratio balances to be maintained with RBI from 99 per cent of the requirement to 95 per cent, RBI also reduced the Marginal Standing Facility (MSF) rate by 75 bps to 9.50 per cent. It had raised this to 10.25 per cent in mid-July, to tighten market liquidity and bolster the rupee, and the MSF had been widely regarded as the effective policy rate.
Rajan, however, said he wanted the repo rate to resume its place as the operational policy rate as the rupee support measures were unwound, returning the gap between the repo rate and the MSF rate to its customary 100 bps. "It could be that we walk more on the MSF side, but it could be that the repo rate will do some of the walking. I want to be, at this point, entirely neutral on what the next step would be. It would be dependent on economic conditions," he said.
While the repo rate would not have any impact on interest rate, as the MSF rate has become the anchor rate, the action revealed the intent of the new governor in fighting inflation. The reduction in the MSF would ease the cost of funds for banks. Lenders were borrowing heavily from that window and Rajan wanted monetary transmission to depend on the movement of banks' costs.
Banks, however, did not seem in a mood to oblige him.
Bankers said festival-related demand for loans, coupled with sluggish deposit growth, might force them to increase interest rates. "The busy season has started, so there is a huge credit demand and banks are scrambling for deposits. Deposit rates, I think, will go up and, accordingly, lending rates can also go up," said State Bank of India Chairman Pratip Chaudhuri.
Banks had seen loan growth of 18.2 per cent till September 6, against deposit growth of 13.4 per cent. The gap could grow as festive-related demand for loans pick up.
While HDFC Bank Managing Director Aditya Puri told a television channel that the base rate would go up but not because of the policy, his ICICI Bank counterpart, Chanda Kochhar, did not comment on interest rates. She merely said the policy signals RBI's balanced approach, a positive for the long-term economic environment and near-term stability in financial markets..
A disappointed India Inc said the RBI missed the opportunity to boost growth at a time when almost all economic indicators were showing a downward trend.
"When an individual starts on a positive note, there are high expectations from him. Today's move, however, indicates that there are limitations to what he can do," said Harsh Mariwala, chairman & managing director of consumer products maker – Marico. Most others said the RBI move to hike repo rate will ensure that the festival season demand would be a washout.