The Reserve Bank of India (RBI) likely to maintain status quo on rates on Jan 28

In its last review in December, the Reserve Bank of India (RBI) was seen supporting growth when it kept the repo rate (the rate at which it lends to banks) unchanged at 7.75 per cent despite high inflationary pressure on the economy.

Before that, since the time Raguram Rajan took charge as RBI governor in September last year, he had twice increased the repo rate by a quarter percentage points. But in December, he surprisingly avoided hiking the rate again.

Clearly, growth is also a concern for Rajan, since high interest rates impact not only consumption but also investments. In his December review, Rajan had reasoned that inflation would fall anyway as it was driven largely by food inflation (which, due to a variety of factors, was expected to decline).

And inflation did subsequently fall. Wholesale price index (WPI) inflation fell from 7.5 per cent in November to 6.2 per cent in December. Consumer price index (CPI) inflation plunged from 11.16 per cent to 9.87 per cent in the same period.

Thus, in the third quarter review of monetary policy of 2013/14, scheduled for January 28 (Tuesday), Rajan is widely expected to keep the rates unchanged again.

However, there are two major factors which could make a case for hiking the rate.

The first relates to the tapering off of quantitative easing by the US. The US Federal Reserve had announced in December that it would reduce its monthly bond purchase by $10 billion every month starting January all through 2014. However, a meeting of the Federal Open Market Committee is scheduled for January 28-29, when it will decide whether to continue the tapering in February or suspend it till there are more signs of the US economy picking up.

But this decision will come only on Wednesday, after the RBI has announced its decision. A higher interest rate gives a better differential rate to US funds investing in India, while a lower one restricts the returns.

Already, the fact that such a meeting is in the offing has sent shockwaves through emerging markets. The Indian rupee, for instance, depreciated by 73 paise against the US dollar on Friday, falling to 62.66. It should be remembered that the rupee which had fallen to 68 against the dollar some time ago, is still vulnerable to external shocks. And if the rupee starts depreciating again, it has the potential of bringing back high inflation because the cost of imports, especially of crude oil, will rise.

Finance Minister P. Chidambaram has said that the current account deficit (CAD) would be restricted to $50 million, or three per cent of GDP, in 2013/14. It was at an alarmingly high $88 billion, or 4.8 per cent of GDP, in 2012.13.

The second is the Urjit Patel committee report which has suggested making CPI inflation the focus, instead of WPI inflation, for determining interest rates. At 9.87 per cent, CPI inflation is way above the RBI’s comfort zone of 4 per cent with a band of 2 per cent on either side. So if the RBI has to reduce CPI inflation to 4 per cent over the next financial year, it has to hike interest rates right away. The Urjit Patel committee’s report, however, is yet to be accepted and some in the government also have reservations about it.

Rajan will surely press the pause button to support growth for the time being. Growth is still weak. GDP growth is expected to fall to 4.8 per cent in 2013/14 against 5 per cent in 2012/13. But agin, global rating agency Moody’s has said the worst is over for India’s economy. “Growth may reach its potential only next year with GDP likely to touch 5 per cent or 5.5 per cent,” says Moody’s Analytics.