Policy normalisation path

RBI will need to do a tough balancing act

The Reserve Bank of India (RBI) did most of the heavy lifting in terms of providing support to the pandemic-ravaged Indian economy. It reduced policy rates and flooded the system with liquidity, which helped ease financial conditions. But that was in the past. As the economy is now recovering, the central bank will need to roll back emergency measures. In fact, policy normalisation would be a key objective for the monetary policy committee (MPC) and the RBI in the next fiscal year. The evolving macroeconomic conditions, however, could complicate policy choices for the central bank.

The MPC decided to leave the policy rate and stance unchanged in its last meeting of 2020-21 on Friday. Clearly, the rate-setting committee intends to support economic recovery to the extent possible. It expects the economy to expand by 10.5 per cent in the next fiscal year. Inflation outcomes surprised on the upside in the current fiscal year, and the rate remained outside the tolerance band during June-November 2020. It came down in December because of a sharp fall in vegetable prices. Core inflation, however, remained elevated at 5.5 per cent. The rate-setting committee expects inflation to remain around 5 per cent till the first half of the next fiscal year. But there are risks to this forecast. While core inflation remains elevated, rising commodity prices — including crude oil — could push up inflation. The MPC noted in its resolution that lowering taxes on petroleum products could help ease cost-push pressures.

Further, the government has decided to run a higher than anticipated fiscal deficit to support the economy. According to the revised estimates — presented in the Union Budget last week — the Central fiscal deficit will expand to 9.5 per cent of gross domestic product in the current year, and is estimated at 6.8 per cent for 2021-22. Higher government spending could exacerbate inflationary pressures. Thus, the MPC will need to make sure that inflationary expectations are well-anchored for the medium term. Sustained negative real interest rates could be a risk in this context. Increased government borrowing and inflationary pressures would also complicate matters for the RBI. Bond yields have risen after the presentation of the Budget, and the RBI could not sell government bonds on Friday because investors were demanding higher yields. The RBI will have to manage a large government borrowing programme even in the next fiscal year while normalising the liquidity situation.

In the current fiscal year, a large balance of payments surplus and the RBI’s intervention in the currency market resulted in excess liquidity in the system. However, with recovery in economic activity, the current account is expected to revert to deficit mode in the next fiscal year. A phased roll-back of an emergency cut in the cash reserve ratio will also affect liquidity. An unavoidable normalisation of liquidity will result in higher borrowing cost. A possible pickup in credit demand would also complicate liquidity management. Thus, the RBI will need to make sure that market rates are not disconnected from policy rates, while potential excess liquidity on account of open market operations don’t end up fuelling prices. It is also allowing individual investors to directly participate in the government bond market through an account with the central bank. This could increase the pool of potential buyers, but individual investors might need some hand holding.