MPC Meet: Is It Time For An Exit From Emergency Monetary Policy?

The Reserve Bank of India was first off the block when the Covid crisis hit. An emergency meeting of the monetary policy committee was called, rates were cut, liquidity was provided and directed where needed. Financial market turbulence was limited. To the extent that monetary and credit policies could help support the economy in times of a health shock, which translated into fiscal shock, the RBI did its job well.

But to every crisis there are two parts—policies intended to manage the crisis itself and the exit from those policies. The RBI gets high marks for the first, but risks falling behind on the second.

A key concern is the deluge of liquidity in the local markets.

The core liquidity surplus, which includes government cash balances, is now at close to Rs 12 lakh crore. That's a historic high level of surplus.

The common refrain is that since much of this liquidity is being parked with the RBI via the reverse repo windows, it will not fuel inflation. It is difficult to see this continuing for long. As Covid uncertainties recede, credit growth will pick up and feed into inflationary trends in the economy. This, when inflation, supply-side or otherwise, is already above the legal mandate. Headline inflation has fallen and will remain low until October, but is set to rise thereafter. It remains to be seen whether the recent drop in monthly momentum of inflation will sustain or not.

While growth remains admittedly fragile, the flood of liquidity is currently helping the strongest, not the weakest. A slow withdrawal of liquidity, if well telegraphed, should not hurt the growth rebound significantly.

In the meantime, the large surplus liquidity could lead to asset price inflation. You only have to look at the large IPO financing by non-bank lenders to see that easy and cheap liquidity could be fuelling bubble-like conditions.

A more important indicator is the call money rate, at which banks lend to each other. This rate, one closely tracked by the central bank, has inched below even the reverse repo rate of 3.35% in recent weeks. If you unpack that rate, bankers will tell you that larger commercial banks can raise funds at well below 3.35%.

In the short-term government securities market, too, 91-day treasury bills were auctioned at below the reverse repo rate of 3.35%, although they are now back above it.

What's worrying is that the central bank is making no effort to withdraw the liquidity.

In fact, it is even adding to it via G-SAP bond purchases and forex intervention. While the latter may be unavoidable to prevent jerky appreciation in the currency, there is no justification for continuing to support government borrowings via the G-SAP bond purchases. The central bank is now balancing out G-SAP purchases with sales of shorter tenor securities to avoid adding liquidity.

A tool like Market Stabilisation Scheme bonds would have been ideal to mop up some of the excess liquidity added, particularly due to forex interventions. But all indications suggest that the government, which issues these securities, is not keen.

That's not to say the central bank is helpless.

Apart from longer term variable rate reverse repo operations, which is the least the central bank should be doing, bond sales via open market operations may have to be considered soon enough. A cash reserve ratio hike, probably the last resort as it tends to be a blunt instrument, should remain on the table for use down the line.

Since the crisis hit, the RBI has been colouring outside the lines of the flexible inflation targeting framework. This may have been justified initially but as normalcy returns, the framework ought to be respected.

Some may not like the inflation targeting framework—many advised against it before it was adopted—but it now exists.

At present, the RBI, by keeping the reverse repo rate outside the purview of the MPC, has effectively rendered the committee decorative—a point highlighted by BloombergQuint previously as well. With surplus liquidity likely to continue for some time, this will remain true as the reverse repo rate will remain the operative rate.

Now, the RBI may argue that it is going strictly by the FIT, which only puts the repo rate under the purview of the MPC. However, that was when the steady-state liquidity framework included maintaining a small deficit, making the repo rate the operative rate. The RBI has deviated from this, making the repo rate an 'also-ran'.

At the last MPC meet, member JR Varma took on this debate and called for a hike in the reverse repo rate, an argument supported by some market participants as well.

Is it up to the government to add the reverse repo rate to the MPC's purview? Perhaps. But recall that the MPC started to vote on monetary policy stance, even though that wasn't included in the FIT framework either.

The simple point—if the RBI wanted, it could perhaps begin discussing the reverse repo rate at the MPC meetings. At the very least, the MPC could debate the appropriate width of the interest rate corridor, while keeping the repo rate as the reference rate.

Another troublesome aspect, albeit slightly more understandable, is the glide path for bringing inflation back down towards to the 4% mid-point of the 4 (+/-2)% flexible inflation target. This path has been been communicated by RBI Deputy Governor Michael Patra, outside the MPC minutes.

There is logic to the idea of a disinflation glide path from pandemic highs, given the growth sacrifice involved.

Finally, the RBI would do well to start communicating its exit and normalisation strategy.

So far, the messaging has been that the baby steps taken via short term variable rate reverse repo is no signal of normalisation. While that is true, the suggestion that normalisation is a distance away is misleading.

Having learnt the lessons from 2013 taper tantrum, the U.S. Federal Reserve has been telegraphing its exit path far more carefully this time. From "talking about talking about taper" to "talking about taper" and then signaling an eventual taper towards year-end.

The RBI is doing the reverse.

While the market is expecting, even calling for, liquidity absorption measures and even a possible reverse repo rate hike over the next two-three policies, the central bank, itself, has done little to prepare the market. Amid this, if data warrants a sharper turn, the market's reaction will be more adverse.

In short—it is time for the RBI to put its exit plan in play.

We don't have to look far in the past to remind ourselves of the costs of a delayed exit from crisis policies. Think global financial crisis. Falling behind the exit curve hurt the economy then; and it may prove costly now.