Resolving A Monetary Policy ‘Multilemma’

A central bank like the Reserve Bank of India is no stranger to dilemmas. There is never a dearth of conflicting policy objectives that it needs to resolve. One could however argue that currently the RBI is stuck with more than its fair share.

Why? It is possible to put policy dilemmas into two boxes. There are the known dilemmas that pop out of the pages of a textbook. The side-effect of hiking interest rates to tame price pressures, for instance, is an appreciating exchange rate. Lowering interest rates to help growth tends to push up inflation. These textbook dilemmas are part and parcel of a central bank’s decision matrix.

The problem arises, as it has currently for the RBI, when there are unanticipated or ‘surprise’ dilemmas that it needs to grapple with. Inflation, to follow basic principles, should have subsided in response to the sharp contraction in the economy. Yet despite a 24% contraction in GDP in the first quarter of 2020-21 and the prospect of a double-digit contraction yet again in the second, inflation continues to print well above the RBI’s tolerance limit of 6%. Hence a new dilemma – can it afford to take its eye off the growth ball in the middle of a deep recession and focus on inflation instead?

Currency And Yield Management

Collapsing growth and a super-easy monetary policy should have meant a depreciation of the rupee. The rupee has appreciated, instead, by 4.5% since the third week of April. Should the RBI try to ‘hold’ the exchange rate by buying dollars, releasing potentially inflation-stoking liquidity into the system, or let the rupee gain?

Expectations of tame medium-term growth prospects—most analysts seem to be revising their forecasts of potential growth—have not brought long term bond yields down substantially. The 10- year benchmark government bond yield is trading at the same level as the third week of May. Does the RBI then take on an additional role, that of yield manager?

A Priority List

As if these dilemmas were not enough, the RBI has to contend with a fiscal deficit that could add up to over 12% for the centre and the states together and result in a deluge of market borrowings. These threaten to pressure up yields on both central and state government paper.

The only way to resolve these myriad dilemmas or ‘multilemmas’ is to rank policy objectives in terms of their priority. The RBI needs to ask itself questions like:

• Is economic revival or inflation the bigger imperative at this stage?
• Is capping long term interest rates through open market operations more critical than harnessing liquidity?

However, the RBI needs to be careful in answering these questions. It should not appear a maverick willing to jettison basic principles of central banking or compromise financial stability to single-mindedly chase growth. This could dent its credibility in the medium-term.

The Options This Week

What does this mean in terms of the specific decisions in the Oct. 9 monetary policy announcement? In terms of priorities, reviving the economy (and indeed ensuring the survival of some sectors) has to be on top of its list. What threatens to impede this process at this juncture is a rise in sovereign bond yields as the markets price in the hefty supply of central and state government bonds. Left unchecked, this could push up interest rates across the spectrum ranging from the rates on corporate bonds to bank loans, and impact adversely on the flow of credit.

Rising rates could also lead to large portfolio losses on the books of financial institutions, losses they can ill afford when most other things—interest margins, loan quality—seem to work against them. Uncontrolled bond yields would also worsen the fiscal situation going forward as a large recurring interest bill keeps future expenditures and deficits high.

The way to handle this is perhaps for the RBI to show its hand. It could declare explicitly in the monetary policy statement that it stands ready to check the rise in yields. Under ordinary circumstances, the RBI might not want to be seen as a meddler in the markets. However, these are hardly ordinary times. Yield management becomes a perfectly legitimate goal for a central bank.

The October policy could also start a discussion on monetisation of the fiscal deficit as a tool of last resort should other options fail to check yields. The least controversial way is to appoint a committee of experts to look into its ramifications. It is quite possible that the RBI might not need to pull out all the stops to get a handle on bond yields. Dwindling credit demand and incentives (in the form of enhanced held-to-maturity) limits banks means that have surplus cash that they would find in their interest to invest in government securities. Neither aggressive open market operations nor monetisation might ultimately be necessary. That said, the bond is seeking a signal at this juncture that the RBI is ready to hold its hand. The central bank should hesitate in sending this signal.

What about the policy rate? It is best to avoid needless controversy by cutting the policy rate in the midst of the high inflation rates. Besides, there is the need to anchor inflation expectations and a pause in the policy rate cycle would help.

However, there is no case for altering its accommodative stance. For one thing, it can draw comfort from the fact going by most forecasts, a combination of a strong base effect and some moderation in food prices will bring inflation down sharply by the end of the fiscal year. Besides, sluggish credit growth means that the large stock of liquidity is not leaking into the real economy to stoke the inflation engine.

The RBI should provide its own forecast of inflation. Simultaneously it might want to indicate that there is space to cut the policy rate further if inflation turns benign. This should soothe the nerves of both borrowers and the bond market.

Finally, there is the question of whether the RBI should follow the U.S. Federal Reserve in a forward-guidance that commits not to hike interest rates for the next couple of years. That might seem like an extreme option. However, given the state of the economy and the niggardly fiscal support, the RBI has every reason to press this button.

Updated to reflect the rescheduling of the MPC meeting to Oct. 7-9 from Sept. 29 to Oct. 1.

Abheek Barua is Chief Economist at HDFC Bank. Views are personal.

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