The US central bank's monetary policy committee (the FOMC) decided to keep its signal interest rate, the Fed Funds rate, unchanged at 5.25 per cent when they met last Wednesday.
There was a lone voice of dissent but other members seemed to believe that price pressures in the US economy would die down as economic growth slackened. Further monetary tightening seems somewhat unwarranted at least at this stage.
The decision to hold rates was widely anticipated and is unlikely to have a major impact on either the financial markets or the global economy. It however endorsed the critical assumptions that most analysts have factored into the forecasts for the global economy for 2007 - that the US economy, the engine of global growth, is decelerating. This is likely to persist over much of 2007 and would affect other economies that are closely linked to the US through trade and investments.
If this assumption does hold, then we are on the threshold of a new phase of the international business cycle where rapid expansion is being replaced by a gentler canter.
The policy responses to this change in the business cycle would have to be significantly different from those that were pertinent to an up-tick in growth. The importance of tomorrow's mid-year policy review lies in the RBI's enunciation of its long-term strategy to navigate the new global terrain.
Traders and analysts are likely to parse the policy statement a tad more carefully than usual to find answers to questions like:
Follow the Fed: Is it always imperative for our monetary policy to be synchronised with monetary policy in the US? Perhaps not. India and the US are in different phases of their business cycle. Unlike the US, India's growth momentum shows no signs of flagging. Its dependence on external trade is relatively low and it might remain out of sync with the international cycle for much of 2007. Thus, the RBI's policy stance could be different from the US or any other central bank that aligns its policy with the US.
However, stepping out of line with the US comes with its own costs that are most visible in the foreign exchange markets. If the RBI decides to raise domestic policy rates in the face of flat rates in the US, it enhances the probability of rupee appreciation, especially in situations where there is extant upward momentum. (This is incidentally the situation at the moment.) In the process, it could end up eroding trade competitiveness, a factor that the central bank had been sensitive to in the past.
This problem gets compounded by the fact that other Asian central banks have co-ordinated their monetary policy with the US. As a result, their interest rate cycles have aligned themselves to the US cycle. Thus, with asymmetric monetary policy we run the risk of letting the rupee go up not just with respect to the greenback but with other peer Asian currencies as well. Most of these economies happen to be our competitors in our export markets.
The absence of perfect capital mobility limits short-term arbitrage and to that extent, the RBI has greater flexibility than central banks that operate in regimes of full capital mobility. However, there are other routes through which capital flows could respond to persistently large wedges between local and global rates.
External commercial borrowings, for one, could rise if domestic rates remain higher than rates abroad. NRI deposits could ramp up. The central bank does have the option of intervening to keep the exchange rate under control but that would result in bloated reserves that would push up money supply.
What is really driving domestic inflation? How does the RBI reconcile the need to maintain some degree of policy synchronisation with the US with the objective of quelling domestic price pressures? A first step for the RBI would be to clearly enunciate what it sees as the principal drivers of headline inflation in India.
There are two issues that are relevant here. First, rate hikes are essentially forward-looking, and even if current inflation is high there is precious little that rate hikes can do about it. Rate changes are known to work with a lag - an increase in the "repo rate" today is likely to impact on prices after six months or more. This has to be borne in mind in gauging any rate decision by a central bank.
Second, moderation in global growth led by a moderation in the US would tend to dampen commodity prices, from metals to oil. This would at some stage filter down to domestic prices.
Thus, if the RBI's forecasts are indeed in line with the Fed, it might decide to hold rates at this stage and wait for the global slowdown to pan out and bring inflation under check.
Thus, high headline notwithstanding, a repo rate hike at this stage might turn out to be sheer overkill if it coincides with a period when global markets are cooling off.
This, incidentally, is exactly the logic that the Fed is using in holding the Fed Funds rate despite persistently high core inflation.
If, on the other hand, the central bank feels that short-term inflationary expectations need to be addressed with a firm hand, it might want to hike the signal rate. The rate decision tomorrow will give the financial markets some clue as to how the RBI sees the relative roles of domestic and global factors in driving domestic inflation.
Bluntness or focus? I am not too sure of how seriously the RBI takes its own research. If it does, then a recent paper by Himanshu Joshi ("Identifying Asset Price Bubbles in the Housing Market," RBI Occasional papers) offers clues to how the RBI intends address the problem of overheated retail credit markets, particularly the mortgage market.
If I understand the paper correctly, Joshi makes a case for using sector-specific instruments (like a change in provisioning requirements) to address these problems rather than a blunt instrument like a repo rate hike. If the decision-makers at the central bank buy this line, these focused risk mitigation measures might become the norm instead of persistent hikes in the signal rate.
The author is chief economist, ABN Amro. The views here are personal.
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