Preserve financial stability

Higher inflation tolerance will increase risks

Lower interest rates and higher liquidity have resulted in record issuance of corporate bonds, with Indian companies raising over Rs 8 trillion from the bond market so far in the current year. Higher liquidity has reduced the spread over government securities and lowered the market interest rates. As Reserve Bank of India (RBI) Governor Shaktikanta Das noted in his statement on monetary policy last week, the spread of AAA-rated three-year bond yields over government bonds has come down from 60 basis points on October 8 to 17 basis points. Yields on lower-rated bonds have also dropped significantly. However, lower interest rates and excess liquidity in the system for an extended period can create risks. Former RBI deputy governor Viral Acharya has rightly argued that as the interest rates spike, issuers will have problems. Rollover will become difficult. Cheaper credit could also push up inflation. The central bank would do well to take such warnings seriously and avoid a build-up of risks in the financial system.

However, instead of containing the potential risk in the financial system, the policy establishment in India seems to be preparing to take more of it to probably boost short-term growth. The government is reportedly planning to recommend a looser inflation target, which will allow the central bank to focus on growth. This is in the context of the review of the inflation target, which is due next year. Currently, the RBI has an inflation target of 4 per cent with a tolerance band of two percentage points on either slide. This is a fairly wide range, and the target or tolerance limit should not be increased for a variety of reasons. For instance, a higher inflation target would mean interest rates will remain low for longer periods. This could result in an excessive build-up of leverage, which will increase financial stability risks. Further, it will push real interest rates deeper into the negative territory and hurt financial savings, which will directly affect investment and growth. Increasing the tolerance limit at a time when inflation has been running way above the target for months would demonstrate the central bank’s inability to maintain price stability. The RBI has been underestimating inflation in recent months and the pickup in commodity prices suggests that it would not come down in a hurry.

At a broader level, the current target has worked well for India and helped anchor expectations. The current spike aside, inflation has remained close to the desired level. A higher tolerance level would affect expectations and influence actual inflation outcomes. It is important to recognise that building policy credibility takes time, and the willingness to accommodate higher inflation so soon after the adoption of the flexible inflation-targeting framework will affect the standing of the central bank. It will also push up the actual cost of containing inflation in the long run. It is correct that in the current situation the economy needs policy support. However, policymakers must take a holistic view and should not compromise on longer-term objectives. Low and stable inflation with well-anchored expectations is important for attaining higher sustainable growth. The adoption of the inflation-targeting framework is a hard-won reform and should not be diluted, particularly at this stage. It’s a no-brainer that higher inflation will dent policy credibility, increase risks to financial stability, and affect long-term growth.