Why RBI Governor Raghuram Rajan is not worried about inflation

Reserve Bank of India (RBI) Governor Raghuram Rajan has given a reprieve to industry and households by keeping the repo rate unchanged at 7.75 per cent despite high inflationary pressures in the economy.

Call it his accommodative stance or the outcome of assurances from the government, but this reprieve comes with a caveat.

Rajan has warned that if the expected softening of food inflation doesn't materialize or if inflation excluding food and fuel does not fall, the central bank will act, including on off-policy dates, if warranted.

The third-quarter review of monetary policy 2013/14 is due on January 28, 2014.

The market was expecting the RBI to hike the repo rate by 25 basis points in its mid-quarter review of monetary policy on Wednesday because of a rise in wholesale as well as retail inflation in the past few months.

The repo rate is the rate at which the RBI lends funds to the banking sector. The rate also dictates the interest rate regime in the economy.

Rajan reasons that the sudden spurt in both wholesale and retail inflation is primarily because of food prices, which are now gradually coming down. "The policy decision (on repo rate) is a close one," says the RBI in its policy review.

Data released this week showed the wholesale price index at 7.5 per cent while consumer price inflation was 11.2 per cent for November.

The RBI makes a strong case that the WPI as well as the CPI excluding food and fuel have been stable. "There is, however, reason to wait before determining the course of monetary policy," says Rajan. "We are not soft on inflation. We are not on hold. We are awaiting data."

This is for the first time Rajan is basing his decision on expectations inflation will ease in the near future. There is already some softening of vegetable prices, including onion, which rose sharply before elections in Delhi, Rajasthan, Madhya Pradesh and Chhattisgarh.

In addition, a stable rupee against the US dollar will also play out into prices. The rupee, which depreciated close to 69, has now stabilised around 61-62 against the greenback. A stronger currency will result in lower import costs especially for oil and gas.

There are also obvious risks including the possibility of a tapering of quantitative easing by the US Federal Reserve. This has all the potential of disrupting the foreign exchange market. "The RBI will be vigilant," it says.

Rajan expects growth in the second half to be stronger than the first half. "There are good news on the agriculture, exports and the long and delayed awaiting of the stalled projects coming on line. It is important, however, that everybody (government and the RBI) be vigilant on the growth front," says Rajan.