Monetary policy: Losing clarity on instruments and goals

(with Harsh Vardhan), Times of India, February 15, 2022

After the Union Budget, economists as well as financial market participants eagerly waited for the Reserve Bank of India to announce its strategy for the coming fiscal year. On February 10, the Governor and the Monetary Policy Committee (MPC) duly outlined their approach. These statements, however, only raised more questions than they answered.

Before the pandemic began, monetary policy was straightforward. The RBI’s objective was clear, as it had a legal mandate under the Inflation Targeting regime of ensuring that consumer price index inflation remained within a 2-6 percent band. Accordingly, at each Policy Review the MPC would set the repo rate at the level it thought would be sufficient to achieve this target. All other interest rates were sideshows, because they were automatically adjusted whenever the repo rate was changed.

Since the pandemic however, the RBI’s operational strategy has changed dramatically. The repo rate has ceased to be the policy instrument, being replaced by the reverse repo rate, i.e. the rate at which banks park their short-term liquidity with the RBI. At the same time, other rates have become detached from the policy rate. So, there is no longer one clear measure of the policy stance, making it difficult to understand what strategy the RBI is pursuing.

After the February 10th review, this confusion has only deepened. Here we highlight four areas of particular ambiguity.

First, it is unclear whether the RBI is maintaining its stance – or tightening it. The official settings have not been changed. But at the same time the Governor emphasized that the effective reverse repo rate has increased from 3.37 percent in August 2021 to 3.87 percent in February 2022, suggesting that behind the scenes policy is being tightened.

How is the RBI doing this? Over the past few months, it has introduced a new facility, the variable reverse repo rate (VRRR) auction. The RBI is now absorbing liquidity under two facilities at two different prices – the reverse repo, with a rate of 3.35 percent, and the VRRR, with a rate of 3.87 percent. Markets expected this anomalous situation to be regularised at the Policy Review, through an increase in the reverse repo rate. But this did not happen. So markets are now confused: what is the RBI’s policy rate?

Second, markets are confused about the RBI’s liquidity stance. During the pandemic period, the RBI injected massive amounts of liquidity into the banking system by buying government bonds, and then stopped as the situation improved. Presumably, the next step would be to wind back the excess liquidity it had created. That would require selling some of the bonds it has accumulated, putting upward pressure on the rates on government securities. Alternatively, it might want to contain G-Sec rates to support the government’s large borrowing programme, but this would entail buying more government bonds, adding to the excess liquidity and risking higher inflation. So, which way is the RBI planning to go? The RBI did not say.

Third, the RBI tried to shed some light on its stance by stating that it will remain accommodative. But this statement has been stripped of much of its meaning. The RBI’s stance has remained “accommodative” across the last 12 meetings, even as it has gone from reducing the reverse repo rate to raising the effective rate, and from injecting liquidity to containing liquidity. So, what precisely does "accommodative" mean?

Finally, the RBI has indicated that it is comfortable with the inflation outlook, predicting that CPI inflation will be 4.5 percent in 2022-23. But can it really be that comfortable? Developed countries are experiencing their highest inflation in four decades, with inflation in the US now running at 7.5 percent. As a result, India faces the risk of importing high inflation. In particular, since the last time retail oil prices were raised, global crude oil prices have increased from USD 75 to USD 90 per barrel. If this increase is passed on to consumers, inflation is bound to rise.

Meanwhile, the Union Budget has announced that it plans to stimulate aggregate demand by increasing capital expenditure, at a time when private sector activity has started to revive. But if the pandemic continues to restrain supply, a significant increase in aggregate demand will only intensify inflationary pressures.

So, there is a real risk that inflation will be far higher than 4.5 percent. If so, what will the RBI do? Again, the market has no idea.

The end result is considerable confusion. It is unclear whether the RBI is committed to low inflation – or to coming up with highly dovish forecasts in order to support the government’s stimulative policy. Nor is it clear what the instruments of monetary policy are, as the repo rate and now the reverse repo rate have lost relevance. So what is the policy rate, and where is it heading? No one knows.

The Governor quoted a line from the late Ms Lata Mangeshkar’s famous song "Aaj Phir Jeene Ki Tamanna Hai". It is wise for us to remember the second line of the song “Aaj Phir Marne Ka Iraada Hai” and note that Tamanna means desire and Iraada means intention!

Budget 2022-23: Hits and misses

Budget 2022-23: Hits and misses, Ideas for India, February 14, 2022.

RBI’s dilemma: Let prices rise or interest rates?

Times of India, February 8, 2022

One of the striking features of the Union Budget was the high borrowing requirement. The government plans to borrow Rs 15 lakh crore in 2022-23, to finance a higher-than-anticipated fiscal deficit of 6.4 percent of GDP. This decision will complicate the policy choices for the Reserve Bank of India.

During the two years of the pandemic, when the government’s borrowing requirements increased manifold owing to high fiscal deficits, the RBI stepped in to make it cheaper for the government to borrow. It lowered the short-term policy repo rate to a mere 4 percent in March 2020. Then, through a series of unconventional actions, it bought immense quantities of government bonds and injected vast amounts of liquidity into banks, to encourage them to buy bonds as well. As a result of these actions, the rate on 10-year government securities fell to 6 percent, even as inflation kept increasing.

The increase in inflation was fairly modest, considering the extent of the RBI’s actions. In ordinary circumstances, a large increase in liquidity would encourage banks to open the credit taps, allowing firms and households to step up their spending, which would then cause inflation to soar. But during the heightened uncertainty of the pandemic, banks were reluctant to lend, households were disinclined to spend, and firms were hesitant to embark on investment projects. As a result, spending was contained. CPI inflation reached the upper limit of the RBI’s target band, but did not spin out of control.

This situation made life easy for the official sector. The government could run large deficits and the RBI a stimulative policy, without worrying about the consequences for inflation. Even better, the advanced countries were pursuing similar policies. This in turn encouraged capital to flow to emerging markets, providing India with additional liquidity and reinforcing the RBI's strategic objectives.

However, in recent months, the global macroeconomic environment has changed quite significantly. After years of price stability, developed countries are experiencing a serious bout of inflation. Inflation has jumped to 5 percent in Europe and 7 percent in the US, the highest in four decades. This change has two implications for India.

First, for the first time in decades, India is now faced with a serious case of "imported inflation". Prices are rising rapidly on all the goods India imports, from oil to investment goods to vital industrial inputs. Even food prices have increased by 20 percent year-on-year as measured by the FAO Food Price Index.

Second, as a result of this global inflation, developed country central banks are getting ready to increase interest rates and withdraw the additional liquidity they had pumped into the system during the last two years. As a result, their policy has begun to diverge from the RBI’s accommodative stance, prompting capital to flow out of India in copious amounts over the past two months. This has weakened the rupee and pushed up domestic bond rates.

With foreigners fleeing the Indian market, domestic institutions panicked when they found out about the Budget borrowing plan, because it meant that they might have to shoulder the entire burden of absorbing the Rs 15 lakh crore that the government is planning to issue. In addition, they would also need to buy whatever amount of government securities the foreign investors are planning to sell in the coming months. Unsurprisingly, the 10-year rate has shot up to 6.9 percent in a matter of days.

This brings us to the RBI. Given the changed global environment and the government’s big borrowing plan, the RBI is faced with two difficult policy options, each with associated risks.

It could resume buying government securities in order to keep interest rates in check. The problem is that buying bonds will inject even more liquidity into the system, at a time when price pressures are intensifying. This could potentially jeopardize the RBI’s objective, since CPI inflation is already running close to its legally mandated limit.

Alternatively the RBI could wind back liquidity and raise the policy repo rate. This would be consistent with its inflation targeting objective, and bring its stance in line with that of the developed countries, thereby reducing the risk of further capital outflows. But it would also push up bond rates, making it costlier for the government and the private sector to borrow.

Both options have their costs. But between the two, the RBI should worry first and foremost about the costs to society of high inflation. Inflation is a tax that falls heaviest on the poorest, the most vulnerable segment of the society. And once inflation starts rising, it becomes very difficult and costly to bring it down, as we learned from our painful experience during 2013-14, when short-term interest rates reached 12 percent. As for bond rates, ultimately they need to be determined by demand and supply, without interference from the central bank, as this is the only way to ensure that they reflect the real cost of capital.

It will be interesting to see which way the RBI goes.