Rajan Seen Holding India’s Key Rate as Modi Takes Power

Indian central bank Governor Raghuram Rajan will keep the benchmark interest rate at an 18-month high to fight Asia’s second-fastest inflation after raising it three times since taking office last year.

The benchmark repurchase rate will be left at 8 percent, according to all 34 economists in a Bloomberg survey before the Reserve Bank of India’s policy review tomorrow, the highest since January 2013. Finance Minister Arun Jaitley agreed with Rajan on the need to curb inflation when the two met last week following Prime Minister Narendra Modi’s landslide election win.

Modi’s control over parliament puts him in position to narrow the budget deficit and boost Asia’s third-largest economy, prompting stocks and the rupee to surge on optimism that India will lead a recovery in the world’s biggest emerging markets. Jaitley said he’d make reducing the fiscal shortfall a priority when he unveils the budget in July, in line with Rajan’s wishes.

“Modi’s government is unlikely to tamper with the RBI’s operational independence as the central bank has great credibility under Rajan,” said Gaurav Kapur, a senior economist at Royal Bank of Scotland Group Plc in Mumbai. “To consider lowering rates, Rajan would need a credible plan from the budget to cut the deficit and boost long-term growth.”

Bond risk for India fell last month while the benchmark stock index touched a record high on optimism Modi will bolster the economy. The rupee weakened 0.1 percent today after climbing 2.1 percent in May, the biggest gain among Asia’s 11 top-traded currencies, according to data compiled by Bloomberg.

Fiscal Discipline

Jaitley said yesterday in a Facebook post that India must rein in spending to benefit in the long term.

“We must move towards an era of fiscal discipline where we can reduce the fiscal deficit, contain inflation and improve upon our growth rates,” he said.

An RBI panel this year proposed a shift to inflation targeting as part of the most sweeping changes in its 79-year history, prompting then Finance Minister Palaniappan Chidambaram to say that economic growth should also be a priority. Jaitley hasn’t commented directly on inflation targeting or Rajan, who paid a courtesy call to Modi yesterday.

Rajan kept borrowing costs on hold in April and said further tightening isn’t anticipated if gains stay on a “glide path” to hit 8 percent in January 2015 and 6 percent a year later as the panel recommended. Retail inflation was 8.59 percent in April, accelerating the fastest in three months.

Inflation Target

Rajan said in February it’d be “good” if parliament or the prime minister sets a medium-term inflation target based on advice from the central bank. The RBI panel in January proposed a 4 percent inflation target, plus or minus 2 percentage points, to be adopted in 2016.

The 1934 Reserve Bank of India Act says the federal government may give direction to the central bank on what it considers the public interest. While high inflation erodes the purchasing power of more than 800 million Indians who live on less than $2 a day, slower growth threatens job creation in the world’s second-most populous nation.

Gross domestic product expanded 4.7 percent in the fiscal year that ended March 31, compared with a decade-low of 4.5 percent in the previous 12 months. Lowering inflation is crucial to spur growth, Rajan said last month, adding that the government must pursue “fiscal discipline” and create a more competitive corporate environment.

Some Tension

“There is always some tension between the government and the central bank, but some constructive tension is good,” Duvvuri Subbarao, Rajan’s predecessor at the RBI, said in a May 24 interview in Singapore. “What’s important is not just the quantum of fiscal consolidation but also the quality of fiscal adjustment.”

Modi faces the challenge of cutting fuel subsidies, allowing more foreign investment and pushing through projects that had been stalled due to delays in approvals. He campaigned on his record of delivering economic growth as chief minister of Gujarat state and promised to stem consumer-price gains.

Modi’s first test will be the budget. Jaitley in February criticized Chidambaram for fiscal laxity over the interim budget in effect for several months, saying deficit reduction had been achieved through cutting capital expenditure instead of boosting revenues or reviving investment. The fiscal deficit for the 12 months ended March was 4.5 percent of GDP, smaller than the previous government’s revised target of 4.6 percent.

BJP Plan

To stem inflation, Modi has called for price stabilization funds and measures to prevent hoarding of food, which makes up 50 percent of the CPI basket. The monsoon, which provides most of the annual rainfall, will be below normal this year amid a 60 percent chance for the emergence of an El Nino that previously caused droughts, the country’s weather forecaster said April 24.

Higher borrowing costs and subdued economic growth has hurt some companies including carmakers. Sales of Maruti Suzuki India Ltd. and others dropped 10.2 percent in April from a year earlier, compared with a 5.1 percent contraction in March, the Society of Indian Automobile Manufacturers said May 9.

“Policy will be based on how the inflation numbers pan out rather than how the markets are behaving,” said Suvodeep Rakshit, an economist at Kotak Securities in Mumbai. “The RBI would want to see actions in terms of reducing food inflation and the budget deficit.”

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