Towards policy normalisation

A delay by RBI could increase risks

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is widely expected to maintain the status quo on both the policy rate and stance in its meeting starting today. Financial markets would, however, want to know if the central bank is now prepared to start the policy normalisation process, or it still wants to wait and support growth by maintaining excessively high levels of liquidity in the system to keep market interest rates low. Short-term market rates have been below the reverse repo rate for quite some time. Aside from flooding the system with liquidity through instruments like targeted long-term repo operations, the central bank also committed its balance sheet through the G-sec acquisition programme, or G-SAP, to manage bond yields. Although a number of steps were taken by the RBI — including the disproportionate reduction in the reverse repo rate — that are technically outside the MPC’s purview, the committee must spend more time deliberating the utility of high levels of liquidity as it has direct implications for medium-term inflation expectations and outcomes.
 

There are a number of reasons why the RBI should formally start preparing for policy normalisation and communicate it effectively to financial markets. As external member Jayanth Varma argued in the last meeting, market rates should be brought closer to the repo rate. Although the headline inflation rate has moderated a bit, and analysts expect it to come down further in the near term because of lower food prices and the higher base of last year, the rate-setting committee will need to be vigilant and should be guided by its mandate of keeping inflation at 4 per cent. The average inflation rate was above the tolerance band in the last fiscal year and the central bank expects it to be at 5.7 per cent in the current year. It is worth noting in this context that global commodity prices have gone up significantly in recent weeks. Higher prices of natural gas, crude oil, and power are affecting industrial production in many economies, including China. Sustained higher global commodity prices and supply disruptions would push up prices in India as well.

Further, economic activity is recovering with increased vaccination. In the present circumstance, excessive monetary accommodation may not be the best policy response. To be sure, there are several sections that have not been able to recover the lost ground. Such businesses and households should be supported through fiscal means because monetary policy is unlikely to help. Excess liquidity in the system can affect both consumer and asset prices with longer-term consequences. Additionally, the government’s revenue position has improved significantly and is likely to result in lower than budgeted borrowing. Thus, the pressure on the RBI to complete the government borrowing programme would be lower and should enable it to address risks to price stability. Although the RBI has allowed the yield on 10-year government bonds to go above the 6 per cent mark in recent months, it should let market rates adjust more broadly. This is not to suggest that the central bank should raise the policy rate. It would first need to bring short-term rates within the policy corridor and then normalise the corridor itself. It is important to recognise that a significant delay in starting this process could increase risks and affect the credibility of the central bank.

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