Return to normal

Higher liquidity is not helping the real economy

The Reserve Bank of India (RBI) has done well to start the policy normalisation process. As widely expected, the Monetary Policy Committee (MPC) decided to maintain the status quo on both the policy rate and stance last week. Since liquidity-related interventions are outside the purview of the rate-setting committee, the onus was on the RBI to take appropriate measures. Governor Shaktikanta Das in his statement, for instance, noted that the RBI was not a prisoner of any rulebook and did not hesitate in taking unconventional steps in order to keep the financial market functioning. To be fair, the central bank did most of the heavy lifting in the initial months of the Covid crisis and responded to the evolving situation. However, there was a growing concern in recent months — as also underscored in these pages — that the RBI was needlessly delaying the normalisation process.

The RBI has addressed such concerns to a large extent and provided a road map to reduce excess liquidity in the system, which was averaging about Rs 9.5 trillion last week. Such a high level of liquidity is not helping the real economy in any significant way.  In fact, there were concerns that higher liquidity could push up both consumer and asset prices. The RBI has thus decided to end its G-Sec acquisition programme, or G-SAP, which was being used to manage government bond yields. A significant improvement in the government’s revenue position means the overall borrowing requirement for the year would be lower. Further, the RBI will progressively increase the 14-day variable rate reverse repo (VRRR) operations. As a result, the level of liquidity available in the system would come down to Rs 2-3 trillion by the first week of December. The RBI may also conduct 28-day VRRR auctions.
 

This will clearly push up short-term market interest rates. The cut-off for the VRRR auction last week came at 3.99 per cent. Reduction in liquidity and relatively high short-term rates would pave the way for a reverse repo hike, which will normalise the policy corridor. This would also push up longer-term bond yields. The challenge for the central bank, however, would be to complete this process in a non-disruptive manner as global financial conditions and capital flows could create complications. The target for the RBI would be to make the repo rate the operational rate as early as possible, which will require a more durable reduction in liquidity. Policy normalisation would re-establish the importance of the MPC and help anchor medium-term inflation expectations.

The MPC has revised its inflation forecast for the current year to 5.3 per cent. Although the inflation rate has come down in recent months, it continues to remain significantly above the target of 4 per cent. The latest projections show that the rate could go up to 5.8 per cent in the last quarter of the current fiscal year, which will be only marginally lower than the upper end of the tolerance band. In this context, global commodity prices would remain a significant risk. Thus, as economic activity normalises with increasing vaccination, the central bank would need to shift its policy focus to maintaining the inflation rate closer to the target. Medium-term growth would depend on a variety of factors, including low and stable inflation.