A one-time Rubik’s Cube world champion is pictured solving the puzzle. (Photograph: Mark H. Milstein/Bloomberg)

Monetary Policy: Managing Conflicting Choices And Puzzling Signals

BloombergQuintOpinion

Policy authorities across emerging economies are facing challenging times. There are abrupt changes in the domestic and global environments. The conflicts between these two are also gaining momentum, through the trade and capital flow channels.

The situation calls on central banks to act like master craftsman, who can address conflicting issues with different tools while also ensuring that they don’t run into a ‘signal extraction problem.’

Some of these conflicts are already plaguing the central bank and the markets.

Bond Purchases: Targeting Liquidity Or Yields?

The first conflict played out in the context of the central bank’s stance on bond purchases.

Bond yields had already been running up since September last year due to concerns over government finances. Against that backdrop, at the post policy press conference in February, Deputy Governor Viral Acharya reinforced the RBI’s stance on bond purchases under the open market operations scheme.

“The goal of RBI’s liquidity operations is not to manage directly the prices of any particular long-term asset market,” Acharya said. This was the appropriate message to send at the time to alleviate investor concerns over the RBI’s dual role of being the government’s debt manager and the monetary authority.

The signal that markets took away from the Acharya’s February statement was that OMO bond purchases were unlikely to happen.

Factoring that in, yields continued to move higher.

Remember that the impact of bond purchases or sales under OMO on bond yields is a byproduct. In other words, central banks do not normally use this tool to influence the yield curve but the impact of OMO purchases or sales on the yield curve is inevitable.

However, markets were surprised and confused when the RBI announced OMO bond purchases on May 8, at a time when liquidity was still surplus.

The central bank, as always, must have had more information than the market. Perhaps, the central bank’s decision to buy bonds was linked to conditions that were changing faster than anyone anticipated. The trade deficit was ballooning due to higher oil prices. This was coupled with outflows from the bond market. There was also a continuous increase in cash in circulation.

Put together, these conditions could have prompted RBI to announce OMOs . But it is important for a central bank to divulge adequate information on a regular basis, so that the system is prepared.

To be sure, in some cases due to the nature of the economy, especially for a twin deficit country, it is not possible to put out every data point or give forward looking information on a regular basis. There could also be a lag between the release date and actual reporting day.

MPC: Dovish Or Hawkish?

The other conflicting signal emerged between the monetary policy statement released after the April review and the minutes of the meeting published a fortnight later.

The tone of the policy statement was seen as dovish while the minutes were seen as hawkish.

This was probably because the policy statement carries the assessment and actions of the authority, designed to address near term variables in sync with medium to long term goals. In contrast, the minutes give you the assessment of individual committee members.

In the end, the assessment and policy prescriptions of individual members may or may not tally with the collective approach which is final statement. The bond markets will perhaps need to learn to gauge the difference between the two.

The Next Emerging Conflict

Those are two conflicts that have already whipsawed the bond market. But there is another which could hit central banks and the market fairly soon.

We go into the June policy review at a time when domestic growth is showing some recovery but inflation is catching up.

The recent rise in core inflation is not entirely because of the growth recovery, but also reflects the shift towards market-based energy pricing in India. The market-based pricing of oil products has helped reduce the difficulty of estimating the primary and secondary impact of a full pass-through of higher oil prices. But forecasting oil price movements and the consequence of those is no less challenging.

On the growth front, recovery is nascent and not broad-based. At a time like this, tight liquidity conditions, put together with the weak financial position of commercial banks and turbulent interest rate markets, could lead to a credit shock for the economy.

Hence, it is imperative to maintain easy liquidity conditions at this juncture, while also ensuring that inflationary expectations are kept in check.

Given these conflicting objectives, we may find ourselves in a situation where the policy rate is hiked but OMO bond purchases are stepped up. On similar lines, you could see a policy rate hike coupled with a cut in the cash reserve ratio.

The hike in rates will be intended to influence inflationary drivers, whereas liquidity adjustments would be aimed at ensuring the smooth functioning of the financial system.

Amidst rising domestic and global uncertainties, it is crucial that the market be prepared for the use of a mix of tools. These seemingly conflicting signals may not be so conflicting after all. Provided the central bank communicates them well and market learns to decipher them.

Soumyajit Niyogi is Associate Director at India Ratings & Research - a Fitch Group Company. The views expressed here are his own and do not reflect those of his organisation.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.