MPC members dive deep on low rates, excess liquidity and sticky inflation

These issues weren't discussed in such details in policy statement, or in post-policy press conference, even when the members seemingly unanimously voted to keep policy rate unchanged at 4%

The minutes of the monetary policy committee (MPC) deliberations released by the Reserve Bank of India (RBI) show that members delved deep into ultra-short-term rates, risk of running huge liquidity, and even transmission of rates not translating into investments while inflation turns sticky.  

These issues were not discussed in such details in the policy statement, or in the post-policy press conference, even when the members seemingly unanimously voted to keep the policy rate unchanged at 4 per cent, and the stance accommodative.  

RBI governor Shaktikanta Das, the minutes showed, was unwilling for a hasty withdrawal of policy accommodation.  

“Overall, the persistence of inflation at elevated levels constrains monetary policy at the current juncture. At the same time, though recovery is underway, there is still continuous need to nurture and support growth to make it broad based and durable. A premature roll back of the monetary and liquidity policies of RBI would be detrimental to the nascent recovery and growth," Governor Das said, the minutes showed.  

The RBI governor preferred to monitor the situation carefully, “both in the sides of growth and inflation.” 

 

“Elevated inflation has checked in and may be here to stay. With retailers striving to recover lost incomes, it is unlikely that margins will ease in the near-term," said RBI deputy governor Michael Patra. 

“Economic activity is recovering but hesitantly and unevenly. This warrant continuing policy support till it is set on a firm trajectory of self-sustaining expansion,” Patra said. 

Even as the multi-speed recovery is faster than earlier estimated, "overall activity is still below its level a year ago,” according to governor Das, while he acknowledged that “investment demand in the economy is still to gain traction even as the transmission of policy rate actions has been sharper and quicker.” 

The governor hoped that the stimulus provided by the government will encourage private consumption, fixed capital formation and push from the supply side, while increase in government expenditure during the remaining part of the year will provide further impulses to growth. The cuts in states’ capital outlays needs to be reversed.  

The RBI governor’s take on soft rates was somewhat countered by external member Jayanth R. Varma, who said "reduction of rates carries significant risks and very little rewards.” 

“The rewards are low because long rates are what are relevant for stimulating investments and supporting an economic recovery; a steepening of the yield curve by a reduction in short rates does not accomplish this,” Varma said. Rather, reduction in long rates is something that the RBI should aim for, as it increases demand in the short run, and stimulates supply in the medium term as the new capacity becomes operational, and this new supply dampens inflationary pressures. 

“By contrast, the demand that is stimulated by a reduction in short rates is not accompanied by an offsetting supply boost, and therefore carries greater inflationary risks,” Varma said, adding a sub 3 per cent rate, corresponding to a negative real interest rate of −4.5 per cent, “risks encouraging speculative inventory accumulation and stoking inflationary buildup in sectors that are showing incipient anecdotal signs of cartelization and resurgence of pricing power.” 

Varma cautioned that the benefits of the soft rates are reaching to a few oligopolistic companies and not all. "I fear therefore that a sustained failure to defend the policy corridor could prove expensive in terms of creating inflationary pressures and inflationary expectations though, so far, low rates have been feeding into asset markets rather than goods price inflation,” Varma said. 

RBI internal member, executive director, Mridul K. Saggar also said persistence of negative real rates for too long can “adversely affect savings, lend support to mispricing of financial asset prices and encourage excessive leveraging.” 

According to Saggar, the output gap will close only in the second half of the next fiscal, therefore, "there is time to normalise monetary policy.” 

Liquidity, credit and monetary aggregates will need to be closely monitored with an eye on macro-financial stability that can be “enervated when short-term borrowing costs fall below the operational policy rate,” Saggar said. 

On the other hand, external member Ashima Goyal was of the opinion that liquidity measures “not only helped firms survive but have also revived demand. The bank credit growth figures show a turnaround but underestimate it.” 

 

As long as the MPC stance is accommodative, durable liquidity will be in surplus and short-term rates will not rise above the reverse repo rate, Goyal said. She supported liquidity creation through RBI’s forex interventions because “overvaluation of the rupee can hurt exports, raise country risk and lead to a sharp depreciation later.” The excess can be removed easily by other policy tools, while maintaining durable liquidity is important, she said. 

According to external member Shashank Bhide, “the sustained recovery of the economy to bring back the lost employment and income to the workers remains crucial policy goal and maintaining moderate levels of inflation is equally important to sustain the recovery process.” 

Despite the overall improvement in the level of economic activities, there are no clear indications of the extent to which the micro and informal sector enterprises have fared. The external demand conditions remain uncertain. 

“On balance, the need to support relaxing the supply side constraints is a priority as this is also needed to address inflation concerns," Bhide said. Improvement in demand conditions requires both fiscal support and decline in Covid-19 threat.