It's time to formalise the normalisation process: Part 1

In many ways, Reserve Bank of India (RBI) Governor Shaktikanta Das’s predicament at the three-day meeting of the Monetary Policy Committee (MPC), the Indian central bank’s rate-setting body, which ends on February 10, reminds me of Larry Fortensky, the US construction worker who was the seventh and last husband of Elizabeth Taylor. Fortensky was well aware of what was expected of him on their honeymoon in 1991 at Michael Jackson’s Neverland Ranch but his challenge was how to be different from Taylor’s previous husbands!

Das knows well what is expected from the RBI against the backdrop of last week’s Budget, which promises to lay the foundation of the world’s fastest growing economy for Amrit Kaal (elixir era) over the next 25 years, but how will he do it?

Tired of hearing endless discussions on the so-called K-shaped recovery, the government wants to roll out the red carpet to all for a post-pandemic party. 

This is being done by spending more. The capex outlay for financial year 2022-23 (FY23) has been expanded by more than one-third, from Rs 5.5 trillion to Rs 7.5 trillion — around 2.9 per cent of gross domestic product (GDP).

If this is not done, the RBI may lose its control over the narrative. With general elections two years away, it will be difficult to counter fiscal dominance if the process doesn’t start now as the borrow-and-spend Budget theme may continue

The role of Atlas

Where will the money come from? Read the fine print of the Budget: The RBI will have to play the role of Atlas.  

In Greek mythology, Atlas, the Titan god of endurance and strength, had to bear the weight of the heavens on his shoulders, a burden handed to him as punishment by Zeus, the god of the sky. Here, the government smartly passed on the heavy-lifting to its central bank to pump-prime the world’s fastest growing economy.

Last Thursday, the Bank of England (BoE) went for a successive interest rate hike for the first time in 18 years and kicked off the process of quantitative tightening. It went for a 25 basis points (bps) rate hike even as four of the nine members of its MPC were for a 50 bps hike. One bps is a hundredth of a percentage point. To fight rising inflation, the BoE policy rate is now 50 bps. In December, it had hiked the rate from its historic low of 1 bps to 25 bps.

Ahead of that, the US Federal Reserve had made it clear that interest rates would be hiked in March, and reaffirmed plans to end its bond purchases. The reason is the same — taming a multi-decade high inflation. The policy-makers have pencilled in three rate hikes in 2022, beginning March.

Despite inflation hitting a record 5.1 per cent in January, the European Central Bank (ECB) has, however, scripted a different story, keeping the policy rate unchanged. ECB President Christine Lagarde reassured the market that the ECB would not rush into any move but she dropped her previous guidance that an interest rate increase this year was “very unlikely”. Even though the ECB has been continuing with its monetary stimulus, analysts have started pricing in two rate hikes this year in the 19-nation Eurozone.

What do we expect from the RBI?

Let’s admit that even though inflation management has become the primary goal of most central banks, there are some critical differences between developed and emerging markets. The fiscal expansion of developed markets to address the pandemic fallout has been far higher than that of the emerging markets; besides, inflation outturns have been somewhat disparate across markets. In many developed markets, inflation has been significantly above the target for a considerable period.

This is not the case in India. It has, mostly, not strayed from the flexible inflation target of 2-6 per cent even though the focus is more on the upper end of the band. Also, there was a marked difference in the state of economies when the first phase of the Covid-19 pandemic hit different nations. India’s growth had slowed ahead of this — in 2016-2019 — and the employment scene was not sparkling. So, just a return to the 2019 level of growth itself doesn’t put us on a very firm footing. This means there is scope for India to not necessarily move in lockstep with the monetary policy adjustments of the developed markets even as we acknowledge that the context is changing. Inflation may not be as transitory as has been estimated since rising demand will add to the supply bottlenecks.

In its December policy, the RBI had kept the rates unchanged and the stance remained accommodative even though Governor Das said that India was “better prepared to deal with the invisible enemy, Covid-19” and “in several sectors of the economy, pre-pandemic levels of output have been crossed”. The repo rate, at which the RBI infuses liquidity, is 4 per cent and the reverse repo rate, at which it sucks out liquidity, 3.35 per cent.

Without changing the rates and beneath a dovish undertone, the RBI strengthened the normalisation process in December, which had started in October, by changing the way it manages liquidity in the system. Besides the reverse repo window, the RBI has been using variable reverse repo rate (VRRR) auctions to drain out liquidity, progressively increasing its size. In fact, the VRRR auction is its main instrument to drain liquidity now. As a result of this, the weighted average rate for such auctions became much higher, making the 3.35 per cent reverse repo rate redundant.

That had been the story so far but the Budget has changed the scenario dramatically.

So, what should RBI do?

Tomorrow: It’s time to formalise the normalisation process – Part II

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd

His latest book: Pandemonium: The Great Indian Banking Story

To read his previous columns, please log on to www.bankerstrust.in

Twitter: @TamalBandyo