Raghuram Rajan’s first step towards “Walk the talk”

Reserve bank of India governor Raghuram Rajan surprised financial markets on Friday in his first monetary policy review by increasing repo rate. Repo rate is interest rate at which RBI lends to banks.

Financial markets took knock as they weren't prepared for rate hike since economy is growing at slowest pace in recent time, manufacturing/industrial production is almost at standstill and some parts of interest rates were already jacked up to defend the Rupee.

But defying expectations, he decided to,

1) Increase repo rate by 25 basis points from 7.25% to 7.5%

2) Reduce the marginal standing facility (MSF) rate by 75 basis points from 10.25% to 9.5%

3) Reduce the minimum daily maintenance of the cash reserve ratio (CRR) from 99% of the requirement to 95%

On his first day as the Governor of Reserve Bank of India Raghuram Rajan said, “The Governorship of the Central Bank is not meant to win one votes or Facebook “likes”. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism. Some of the actions I take will not be popular.” Guess he was giving signal to markets that he is not here to please, but do the right thing!

By taking these steps he

1) Set his priority of “anchoring inflation and inflation expectations”. He thinks in the absence of an appropriate policy response, WPI inflation will be higher than initially projected and CPI inflation is worrisome. He wants to be ahead of the curve to achieve his target instead chasing it after it goes beyond control. But that doesn't mean he will sacrifice growth to have disinflationary pressure. He believes low and stable inflation in turn boost savings and investor confidence in the economy. He said in concluding remark, “the Reserve Bank will closely and continuously monitor the evolving growth-inflation dynamics with a readiness to act pre-emptively, as necessary”. Here we should remember his first day’s “A central bank should never say “Never”!” remark.

2) & 3) Is reversing some of the steps, which RBI had taken to fight the Rupee depreciation and volatility. These will take care of liquidity pressure in the banking system, additional cost of funding and send out the message loud and clear that normalizing monetary policy operation. Going ahead once the reverse repo-repo-MSF corridor come to normalcy (100 basis points difference between each), repo rate will resume the operational policy rate role.

After watching his media address (following policy review) and listening to teleconference with researchers and analysts, one thing he made sure that he is here for change. Same thing he conveyed on the 4^th September, “It involves considerable change, and change is risky. But as India develops, not changing is even riskier.”

Repeatedly he clarified things like Urjit Patel and team working on an inflation model to target instead of either plain WPI or CPI. Unusual but unique, Rajan is trying to do the balancing act between inflation anchoring, easing liquidity measures and bringing back the normal monetary operation procedure.

Now there are pitfalls in his walk. Being election year will finance minister allow him to take his own decisions and if yes how long? Rajan needs to take Chidambaram and Prime Minister Manmohan Singh into confidence. How long will he be able resist the temptation of growth friendly policy than targeting inflation? Will he able to balance between 3 legs of the impossible trinity in worst case? Will he be transparent in communicating policy guidance, without surprising too many times?