Like the rest of the market, I was somewhat surprised by the Reserve Bank of India's (RBI's) rate hike on March 19. The element of surprise related entirely to the timing of the move, says Abheek Barua.
Senior officials of the central bank earlier seemed to suggest that rate changes would be kept for the quarterly monetary policies and not sprung on the market between policy meetings. Thus while there was compelling logic behind a rate hike at this stage, most of us had expected it in the April policy.
Why RBI was in such a hurry will remain a bit of a mystery. Perhaps it was the realisation that its failure to respond to headline inflation with a forceful signal had dented its credibility as inflation fighter.
Indeed, murmurs that RBI was listening too closely to the fiscal managers in Delhi in accommodating growth and the large borrowings of the Central government and ignoring inflation in the process were getting more audible.
Unflattering comparisons were being made (somewhat unfairly in my opinion given the change in circumstances) between former RBI Governor Dr Reddy's no-nonsense approach to maintaining the price level and the current regime's play-it-by-ear strategy. The rate decision should put some of these concerns to rest.
Issues of credibility aside, there were a couple of developments after the January policy that might have helped RBI take this first step towards reversing the rate cycle. For one, there was more data on inflation available that clearly pointed to a rapid increase in "core" or non-food inflation. (Core inflation is perceived as largely demand-driven and is thus responsive to monetary intervention).
When RBI took its policy decision in January, it had inflation data only up to December 2009. In December, core inflation had turned positive but was relatively low at 0.7 per cent.
When RBI took its decision last month, it had the January and February data to go by. In January, core inflation had perked up to 2.8 per cent and in February it clocked 4.5 per cent
Second, after a somewhat rocky February, global financial markets began to stabilise by the middle of March. There were actually two critical developments on this front.
For one, a process that I would describe as the "localisation" of the European sovereign default risk had set in by the second week of March. Thus the risk of a European government defaulting on its debt obligations was getting priced into European financial markets alone and not spilling over to other asset markets.
One just needs to see the diminished correlation between the euro-dollar and the rupee-dollar exchange rates to appreciate this phenomenon. Thus, India and other emerging markets seemed to have to have decoupled from Europe's woes.
Second, in their public statements in February and March, US Fed officials made it abundantly clear that they were not likely to squeeze dollar liquidity in the near future.
Thus while it was not likely to add more liquidity (the Fed's quantitative easing programme ended in March), it would not try to suck out liquidity through open-market operations. Policy rate hikes in the US are unlikely this year.
Thus, if RBI had increased rates in January, it ran a major risk. If the increase in reverse repo and repo rates had coincided with a sharp decline in capital inflows, local rates could have spiralled. By March 2, there seemed to be enough assurance that the external environment had turned benign.
Domestic markets seem likely to get adequate support from external liquidity flows. Thus it had become easier for RBI to send a signal without risking an immediate spike in rates.
How much more should RBI hike? Opinion is sharply divided on this. Investment bank "forecasts" are often more prescriptive rather than predictive and if one were go through a list of "calls" made by the heavyweight international banks, a rate increase of at least a percentage point and a half is warranted.
There are extreme views, of course, with the venerable Goldman Sachs apparently (I haven't read the report) predicting an effective increase in policy rates of three percentage points. This, of course, does not mean that each of the policy rates should rise by that quantum.
What Goldman seems to suggest is that the central bank will also tighten liquidity to a point at which banks are forced to borrow from RBI at the repo window. Given the difference of a percentage point and a half between the reverse repo and repo rates, this entails a jump in the short-term policy rate by that quantum.
Add a percentage and half point increase to the repo rate and you get a policy rate increase of three big figures. Policy boffins in Delhi quite predictably take the opposite view and advise caution, and for once I am on their side.
I am aware that inflation will remain high at least until October and won't just be driven by supply factors. RBI does need to keep signalling to the markets that it is tough on inflation.
But equally importantly, there is a Rs 2,87,000-crore government borrowing to manage in the first half (and Rs 1,70,000 crore in the second) and the need to ensure that the incipient investment recovery doesn't fizzle out.
Global risks may have dissipated but who knows what's around the corner. Those who obsessively use phrases like "staying ahead of the curve" when it comes to the central bank's monetary policy perhaps need to do a reality check.
If we look around us, we can hardly find central banks that are aggressively tightening their monetary policy. There is no need for Dr Subbarao to stand out from the crowd and play Paul Volcker. A cumulative increase in policy rates of about three quarters of a percentage point (75 basis points for the initiated) over this financial year should do the trick. No more, not less.
The author is chief economist, HDFC Bank.