The power of forward guidance

One of the defining moments of the policy announcement is continuing to maintain an explicit forward guidance of keeping the rates and accommodative stance on hold till at least mid-2021, a practice initiated by Sveriges Riksbank. Many large central banks, such as the ECB, were initially averse to such an idea, favouring a more implicit rather than explicit guidance — like Lucas Papademos, a former vice-president of the ECB. He had differed with the erstwhile Fed Chairman Ben Bernanke who was more explicit in outlining the course of Fed measures after the Lehman Brothers debacle. Bernanke argued, and correctly, that explicit forward guidance may be more useful to assuage market sentiments when uncertainty is very high, and in EMEs — having inadequate market depth and being more reactive — explicit forward guidance is more appropriate. From that perspective, the MPC’s stand in this and the previous policy is perfectly justified.

The point of dissonance is, however, regarding the surplus liquidity sloshing around the banking system and the fear that it might endanger financial stability. In this context, the point of debate could be the differentiation between structural (a result of deposit and money growth) and cyclical liquidity caused by central bank policy actions (OMO, TLTRO, CRR, forex intervention, etc).

Ideally, structural liquidity should always counterbalance the latter, but in the current exceptional circumstances structural liquidity far outpaces cyclical (at least 2.2 times larger) and hence any move to withdraw the latter now may not have served the purpose and additionally created financial instability as market sensitivity to RBI liquidity operations has been remarkably stronger than its response to structural factors for successful interest rate stabilisation. Interestingly, liquidity management through both quantum and rate channels, as is being done right now, is a feature specific to EMEs. Additionally, linking inflation to liquidity, we believe, is still a complex exercise as it depends on a host of other factors like identifying the feedback loop in transmission framework, declining money multiplier etc.

On the regulatory and development policy front, the measures are noteworthy. Extending the TLTRO facility to the 26 stressed sectors and encouraging banks to synergise funds from the RBI under on-tap TLTRO and guarantee under ECLGS 2.0 to provide credit support to stressed sectors is a good policy innovation. The decision of extending the LAF to RRBs is a welcome move, which will help the RRBs to enlarge the ambit of reverse repo (at least Rs 50,000 crore is a rough estimate of surplus) and possibly anchoring the short-term rates. The policy has also placed considerable emphasis of behavioural aspect of conduct of financial transaction by harmonising guidelines on appointment of Statutory Auditors for Banks and NBFCs. The RBI has also directed that SCBs and cooperative banks shall not make any dividend payout from the profits pertaining to FY20. This will surely augment the Tier-I capital. The ease-of-doing measures on trade financing are also good.