Stay on target

Stay on target

RBI surprises by not raising interest rates.

Reserve Bank of India retained its policy interest rate at 6.5% yesterday, making it an outlier among Asian central banks facing similar challenges. There is dissonance between RBI’s outlook and recent events in financial markets. The BSE Sensex ended yesterday at 34,376.99 points, lower by 2.25%. During the week it fell 5.11%, the largest weekly fall in 31 months. The rupee closed at 74.23 against the US dollar yesterday. It’s fallen more than 14% since January, making it the worst performer among major Asian currencies. Yet, RBI didn’t raise interest rate to defend the rupee.

The dissonance is explained by the monetary policy statement’s highlight. RBI has lowered its inflation forecast for the rest of the financial year as low food inflation has offset the impact of rising oil prices. According to RBI inflation in key food items remains “exceptionally soft at this juncture.” At the same time, GDP forecast for 2018-19 remains unchanged at 7.4%. Domestic factors seem under control. Risks to the economy stem from external factors. It has shown up in an outflow this year of foreign portfolio investment.

Financial markets are being rocked by higher interest rates in US, escalating trade wars and an aversion to risk in the wake of uncertainty. There is just one line of defence against external risks: keeping critical macroeconomic parameters under control. Inflation is under control and appears unlikely to shoot significantly above RBI’s target of 4%. It’s important to complement it with fiscal rectitude. Unlike 2013, the government only needs to stick to its targets and also deny states extra space to borrow. Good macroeconomic indicators are the best way to insulate the economy from the volatility evident in financial markets. RBI and government now need to stay on target.