Governor Raghuram Rajan has made it clear that his first priority is to anchor inflationary expectations. He has decided he will court unpopularity but do the right things

Reserve Bank of India Governor Raghuram Rajan may have disappointed the markets, but he has lived up to his reputation of delivering a clear message from monetary policy: he has put inflation fighting at the top of his agenda by raising the repo rate by 25 basis points to 7.5 percent. Nobody expected him to do this and this is why the markets have been partying till today. The repo rate is the rate at which banks borrow short-term from the RBI.

In doing so, he has also made it clear that he is not going to court cheap popularity with the markets or the powers that be by easing rates prematurely.

What is equally important is what he has not done: despite tight liquidity conditions, he has declined to cut the cash reserve ratio (CRR), which is the money banks have to maintain with the RBI at zero interest.

Though there are some palliative measures to ease short-term liquidity - like the reduction in the rate of the marginal standing facility from 10.25 percent to 9.5 percent, and a slight cut in the average CRR balances to be maintained with the RBI from 99 percent of the requirement to 95 percent - what Rajan has effectively done is to take D Subbarao's warnings on inflation to their logical conclusion: high expectations on inflation ought to mean costlier money.

Rajan's statement will thus not come as any balm to the finance ministry, which had earlier portrayed Subbarao as the villain of the piece. Rajan clearly said that his priority was to break the back of inflationary expectations. He said: "The current assessment is that in the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year. What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence."

The reference to "absence of an appropriate policy response", when translated, means it is the finance ministry that needs to take action to reduce the fiscal deficit and reduce inflation. P Chidambaram will have to walk alone for some more time before Rajan chooses to join him in reviving growth.

Rajan's second priority is to address the current account deficit (CAD), which is the primary cause of the rupee's recent decline. Once again the finger points to the finance ministry. He said though steps have been taken to address the CAD issue, the "focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation." This again is a nudge to Chidambaram to act.

The Governor also went out of his way to douse recent animal spirits in the stock markets which were buoyed by the US Fed's decision to continue with its bond purchasing programme and keep interest rates down. The markets took this to mean that the RBI will also take the opportunity to ease its policy. But Rajan went out of his way to kill those hopes. He said even though the US Fed decided not to taper its bond purchases right now, it was "inevitable." He emphasised: "The decision by the US Federal Reserve to hold off tapering has buoyed financial markets but tapering is inevitable."

As a prudent Governor, Rajan is clearly not planning to use the US Fed's decision to make imprudent monetary easing himself. This is why he said that no matter what happens, the RBI is ready to move rates in either direction - up or down - depending on circumstances. But his tone was hawkish. "The timing and direction of further actions on exceptional measures will be contingent upon exchange market stability, and can be two-way. Further actions need not be announced only on policy dates. However, any further change in the minimum daily maintenance of the CRR is not contemplated."

That he went out his way to say the CRR won't be eased is significant. It shows that he does not intend to be swayed too much by political considerations on interest rates and monetary easing.

Even though the government has been talking of inflation easing up after a good harvest, Rajan is not taking chances. "As the inflationary consequences of exchange rate depreciation and hitherto suppressed inflation play out, they will offset some of the disinflationary effects of a better harvest and the negative output gap. The need to anchor inflation and inflation expectations has to be set against the fragile state of the industrial sector and urban demand. Keeping all this in view, bringing down inflation to more tolerable levels warrants raising the LAF repo rate by 25 basis points immediately." Rajan thinks there is more inflation to come - which is why he is talking of "suppressed inflation."

Rajan's final words make it clear that his primary job is to defend the rupee's value even while winding down exceptional measures taken in July to tighten short-term liquidity. He said: "The policy stance and measures set out in this review begin the process of cautious unwinding of the exceptional measures, which will restore normalcy to financial flows. They are also intended to address inflationary pressures so as to provide a stable nominal anchor for the economy, thereby mitigating exchange market pressures and creating a conducive environment for the revitalisation of sustainable growth."

The bottomline is clear: Raghuram Rajan is not going to be the government's poodle when it comes to taking independent policy decisions. Chidambaram will have to talk alone for a while before Rajan chooses to oblige him with a rate cut.