India may need some durable liquidity infusion: MPC member Ashima Goyal

In a Q&A, she says the majority opinion is that the country has handled the turbulence well and can do so again, though the probability is low in the immediate future

Given that the Reserve Bank of India’s short-term liquidity management facility faces difficulties handling large external shocks, some injections of durable liquidity may be required for credit growth to be adequately supported, Ashima Goyal, a member of the Monetary Policy Committee told Bhaskar Dutta in an exclusive interaction. Edited excerpts:

You mentioned that the current level of the repo rate is a satisfactory focal rate. Are you convinced of a durable fall in inflation, given that the MPC projects a rise in the second quarter of the next year?

A: There is large uncertainty around inflation forecasts. On the whole, downside risks are more for MPC inflation forecasts.

Q: You have flagged multiple supply shocks as the reason behind the persistence in core inflation. By when do you expect core inflation to meaningfully head towards 4 per cent?

A: The two-year period the governor has indicated gives time for global supply shocks to unwind. It is already in process and may happen earlier, especially if the global growth slowdown is severe. There are no true second-round inflation propagators, such as rising wages or excess demand, in India as yet.

Q: You have talked about high interest rate spreads, repeated episodes of the call rate trending above repo and the need for durable liquidity buffers. Is it time for the RBI to restart purchases of government bonds in the open market?

A: They have to take a call on whether, at current levels of durable liquidity, they are able to compensate for exogenous liquidity shocks by fine-tuning short-term liquidity. As governments start to spend, drawing down cash balances, reserves rise with a return of foreign inflows, and as advance tax payments are completed, durable liquidity levels should be more comfortable.

Q: You mentioned the case of the Bank of England and communication when it comes to the distinction between market-making and the monetary policy function of liquidity. Could you elaborate on how the MPC should ensure support of credit amid higher repo rates? Could it undermine the efficacy of a tightening cycle?

A: Advanced economy (AE) operating systems used to keep durable liquidity in deficit, injecting short-term liquidity into the system as required to maintain the announced policy rate. This was thought to enhance monetary policy transmission. India’s inflation targeting regime aimed to follow this system, keeping durable liquidity in deficit and the call money rate at the repo rate. This meant that in easing cycles, liquidity would be in deficit, which markets found difficult to understand.  But AEs themselves moved away from such a procedure under quantitative easing, when huge excess durable liquidity was created. Tightening cycles under Fed chairs Janet Yellen and now Jerome Powell took place with excess liquidity.

In India, the comparatively limited expansion in RBI’s balance sheet during the Covid-19 episode has largely reversed now. But an emerging market is subject to large unpredictable liquidity shocks. During the early years of inflation targeting, short-term endogenous liquidity adjustments were unable to compensate for large shortfalls in durable liquidity when it was kept in deficit. In 2018, for example, a severe liquidity squeeze had many adverse consequences. Credit growth fell to unprecedented lows.

The system has deepened further, so more fine-tuning is possible using endogenous changes in short-term liquidity to keep the call money rate close to the repo rate. But it is safer to keep durable liquidity in surplus, since potential shocks are large.

The repo rate is the monetary policy signal. Durable and short-term liquidity can adjust in any direction as required to achieve it. BoE reversed sales of g-secs for a short-period and clarified that it was only to reduce market-volatility and was independent of the monetary policy function. Because of large leverage and over-dependence of central bank liquidity after quantitative easing, many advanced economy central banks may have to do this. In India, some injection of durable liquidity may be required because of large external shocks that the short-term liquidity management facility is as yet unable to handle. If it happens, markets should not interpret it as a reversal of the tightening cycle.  

Q: You talked about volatility imparted by communication shocks from major global central banks. The Federal Reserve surprised on the hawkish side in December. How would the rupee deal with another wave of dollar strength?

A: As the issuer of the reserve currency and the beneficiary of the special privileges it entails, the Fed has a responsibility to the world. Especially under uncertainty, communicating that decisions will be data-based reduces volatility, since real sector changes compensate for policy actions. For example, a rise in growth neutralises the impact of a rate rise on markets. So a rate rise conditional on macro data creates less volatility. Hawkish or dovish forward-looking statements are best avoided.

The market assessment seems to be that the dollar will weaken from here, since it has overshot. Many AEs are raising policy rates now. Most of the adjustment seems to be over. The majority opinion is India has handled the turbulence well and can do so again, though the probability is low in the immediate future. Multiple instruments used included exchange rate flexibility, intervention, tweaking capital flow rules, macro-prudential and current account adjustment measures. These work better than over-reliance on any one measure and are available because of India’s sequenced approach to capital account convertibility. They give monetary policy the independence to do what is best for the domestic cycle. Two-way movement in foreign exchange reserves has to be expected and is nothing to be concerned about, especially, since it is only a small fraction of total reserves.