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What's there on RBI's mind?

Last updated on: February 16, 2012 10:54 IST

What's there on RBI's mind?

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Devangshu Datta in New Delhi

Long before behavioural finance became a popular theme, central bankers took psychology into account.

Monetary policy aims at modifying crowd behaviour.

By tightening or loosening money supply and tinkering with interest rates, central banks try to nudge economies in the right direction.

One primary axiom for a central bank is to keep everyone guessing.

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If other actors figure out the bank wants a certain exchange rate, or it is targeting a specific inflation rate, they may react in ways that are sub-optimal.

Central banks also realised behaviour is linked more to future inflation expectations than to current inflation levels.

In the 1980s, the US Federal Reserve developed a very harsh inflation doctrine, consisting of raising rates till all inflation expectations had been squeezed out.

In the late 1990s and early 2000s, Fed policy swung in the opposite direction.

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At the slightest signs of trouble anywhere, it would loosen money supply.

The excess liquidity, eventually, caused a massive bubble with all asset valuations rising. Since the dollar is, for better or worse, the global default currency, that bubble affected the global economy.

For the past four years, the world has been struggling to deflate that bubble without any catastrophic ramifications.
India was a beneficiary of the boom.

It attracted large inflows.

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Now, it is walking a tightrope to ride out the bust.

Since the government is paralysed, the only policy option is via the Reserve Bank of India.

What are RBI's targets and what is its inflation doctrine?

Inflation versus growth is the balancing act.

Growth or the lack of it, is somewhat sensitive, while inflation is a very politically sensitive subject in India.

The central bank doctrine is generally inclined to be on the harsh side.

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Many states are going to the polls this year.

This could keep the RBI from loosening.

But the case for rate cuts is becoming stronger with every new data point.

The index of industrial production has shown consistent weakness in the three latest months.

The wholesale price index has fallen to a 26-month low. Growth has shown weakness in the last two quarters.

Corporate results have been anaemic.

The gross domestic product estimates have been scaled down.

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If these aren't enough to induce cuts, one will have to assume RBI has very specific targets for inflation and perhaps a fear of major currency fluctuations.

The market is now factoring a big rate cut in April into valuations.

It is also assuming that will be the start of a trend of a falling rate cycle. If those expectations are belied, the results will not be happy for bulls.

Are these what the RBI wants?



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