Monetary Policy: Complex Economic Realities To Test RBI’s Tactical Prowess
India, like the rest of the world, is facing two acute challenges – one medical and the other economic. A remedy for the medical problem remains elusive even though there have been promising developments in the quest to find a vaccine for the Covid-19 virus. In contrast, remedies for the economic challenges are theoretically available but practically difficult to employ.
When India’s Monetary Policy Committee and the RBI review monetary policy this week, they will need to weigh the theoretical with the practical and tactically deploy the tools available to achieve the best results.
The Crisis Response
First, a brief overview of what the MPC and the RBI have done since the outbreak of the Covid crisis.
The MPC has cut the policy repo rate by 115 basis points to 4%, to a historic low. The reverse repo rate has been cut by 155 basis points to 3.35%. Additionally the cash reserve ratio has been reduced by 1 percentage point to 3%. Various initiatives have been announced to ensure more than adequate banking system and funding liquidity.
The results are encouraging. Market liquidity condition have been improving. Interest rate transmissions in the markets and through banking channel has been satisfactory, particularly given the sharp increase in supply of government bonds.
Weighing The Data
The initial response was intended to fire-fight against possible dislocations in markets. This was evident from the nature of the response and the fact that decisions were taken in two consecutive off-cycle meetings.
This time, as the MPC sits down for a scheduled meet, it will need to weigh the data evidence of economic damage but also balance it against its legal mandate.
What the data shows so far is that while growth has nosedived, inflation has picked up. Headline consumer price inflation crossed the MPC’s threshold ceiling of 6% in June 2020. Since 2016, barring one occasion, realised inflation has always stayed below the threshold limit, until recently.
The monetary policy framework allows the MPC to tolerate higher inflation for three quarters. However, the committee will also be concerned about credibility and ensuring that inflation expectations don’t come unanchored.
The question the MPC will be debating is whether the pick-up in inflation is transitory or if it has the potential to become generalised. At this stage, stagflation seems to be a remote possibility due to ample idle capacity and technological advancements. But, in the current environment, no risk can be ignored.
Pause And Shock Versus Tactical Comfort
Typically, when data trends are muddy, the MPC would pause and wait for clarity. But given the current environment, can the MPC and RBI afford to pause and shock the markets?
A pause, at a time when the economy remains in crisis, may send the wrong signal to the economy and the financial system. It will depress the sentiment and weaken interest rate transmission.
In economics, there is no perfect solution. It all about finding the optimum solution in sync with the objectives.
This will achieve two objectives. First, the reverse repo rate cut will send a dovish signal to the financial intermediaries like banks. Second, it will disincentivise banks from parking money in the reverse repo window instead of lending or investing.
Meanwhile, the pause in repo rates will be a signal that the MPC remains watchful of inflation.
This tactical combination of a reverse repo cut with a repo rate status-quo may also prove to be useful in the medium term. It will allow RBI to ensure a calibrated exit from the current ultra-loose policy strategy. For instance, if inflation remains sticky and recovery gathers steam, the RBI can think of hiking the reverse repo rate before it moves on the repo rate. This will ensure that a nascent recovery is not damaged by premature rate hikes.
Watch The Yield Curve
There is one possible casualty of the approach described above – the yield curve.
Pushing down the reverse repo rate to rock-bottom levels will cause a further steepening of yield curve. This could be countered by conducting more ‘Operation Twist’-like auctions or by issuing short term securities at a regular intervals.
Even so, the risk of an uptick in long term yields remains if fiscal conditions worsen further. This may keep banks away from taking on the duration risk associated with longer dated bonds. Lenders, who are already facing asset quality and capital pressure, may be reluctant to add to their woes with mark-to-market risks.
In normal circumstances, the RBI could do large scale bond purchases under its open market operation programme to keep long term yields low. But that may not be easy at a time when India’s balance of payments surplus means a strong flows of foreign exchange into the country. As the RBI absorbs this foreign exchange, it is already pumping liquidity into the system.
The solution may lie in increasing the limit for bonds in the held-to-maturity bucket of lenders.
This could be done in a staggered manner and for longer-dated paper such as government bonds of over 10-year maturity.
No doubt, adopting a mix of instruments, such as the combination suggested above, will be complex. But these are complex economic times, with no easy solutions.
Soumyajit Niyogi is Associate Director at India Ratings & Research – A Fitch Group Company. Views are personal.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.