Managing markets

Bond and currency markets would increase policy difficulties

The US Federal Reserve has announced a notable shift in its policy strategy. Addressing an annual economic policy symposium last week, Fed Chairman Jerome Powell noted the US central bank would now “seek to achieve inflation that averages 2 per cent over time”. Thus, after a period when inflation undershoots the target of 2 per cent, the Fed would aim to keep it above the target for some time. Effectively, this means interest rates would remain low for an extended period. While the new approach might cause confusion in financial markets over the medium term, it will result in higher capital flows into emerging markets in the foreseeable future. It is important to note that even the record low rate of unemployment before the pandemic did not result in higher inflation in the US.

Higher capital inflows would increase policy difficulties in India at a time when imports have collapsed owing to weak demand. The Reserve Bank of India (RBI) is accumulating foreign currency and has added reserves worth about $60 billion so far in the current financial year. The RBI’s intervention in the currency market has resulted in higher rupee liquidity in the system. However, despite excess liquidity, longer-term bond yields are rising because of higher inflation and large government borrowing. The RBI, for instance, could not sell a large part of government bonds in the market last week because of higher yields. The problem for the Indian central bank is that it cannot freely intervene in the market to influence longer-term yields because of excess liquidity. Bond buying by the RBI will inject more liquidity into the system and can affect inflation outcomes.

Therefore, the central bank has been trying to contain longer-term yields by simultaneously buying and selling long- and short-term bonds. However, the efficacy of such moves may increasingly get limited because of the size of the government borrowing programme. State governments are also expected to borrow more. Further, although the details of the proposed borrowing to compensate states for the shortfall in goods and services tax collection are not clear, it could end up putting more pressure on the bond market. Managing both the bond and currency markets at a time when inflation is running above the target band will be extremely tricky for the RBI. If it takes its hands off the currency market, which it seems to have done last week, the rupee will appreciate and affect India’s external competitiveness. Even though it will help contain inflation in the short run, currency overvaluation is undesirable for the overall economy.

Since capital inflows are likely to remain strong, given the change in the Fed’s policy, the government and the RBI would be well advised to revisit the kind of flows India needs over the medium term. Since India has adequate reserves, it can discourage short-term debt flows. This would also reduce risks to financial stability. The government would also need to clearly communicate its borrowing requirements. It is important to recognise that higher borrowing will result in higher yields and there are limits to which the RBI can manage the cost without compromising financial stability. Therefore, both the government and the central bank will need to be prepared to deal with the evolving policy challenges.