RBI can pare excess liquidity even if stance is accommodative: Ashima Goyal

In a Q&A, Goyal, a member of RBI's Monetary Policy Committee, says reducing excess liquidity is at RBI's discretion and MPC members can only offer advice

Ashima Goyal, a member of the Reserve Bank of India’s Monetary Policy Committee voted in favour of keeping the repo rate unchanged and maintaining an accommodative stance during the August monetary policy review. In an interview to Business Standard, Goyal, who is a professor at the Indira Gandhi Institute of Development Research (IGIDR), says reducing excess liquidity is a discretion of the RBI and MPC members can only offer advice. Edited excerpts:

Q. You have used the phrase “whenever normalisation starts,” indicating it has not started yet, though a section of the market believes that it did with the VRRR announcement. What according to you will mark the start of the normalisation process? Is reverse repo rate hike the right indicator?

The current VRRR (variable reverse repo rate) is a short-term kind. It could just be part of their normal liquidity management, especially since excess liquidity is very large. That is what they are saying. The market is just inferring from these actions. I don’t think there is enough evidence to say that normalisation has started.

But the point I want to make is that RBI can reduce excess durable liquidity, and respond as required based on outcomes, even if the stance is accommodative. Although the MPC sets the stance also, this basically determines potential repo rate actions—whether it can rise or stay the same or it can fall. The stance does not determine what happens to liquidity. That is RBI’s discretion. How they handle the excess liquidity or what happens to the reverse repo is their discretion. MPC members can only offer their opinion or advice.

Q You have said “other normalisation can start when the stance is accommodative…”

This is what I am clarifying. That they can make changes in the amount of liquidity available, even change the reverse repo, when the stance is accommodative. Exceptional actions were undertaken during the pandemic. The gap between the repo and reverse repo is 65 bps, larger than normal. Durable liquidity is excessive. So normalisation that reverses exceptional measures can happen in an accommodative stance. But that is the RBI’s call and not the MPCs.

Q Do you think rate normalisation can happen only after the gap between repo and reverse repo is restored to 25 bps?

No. The process of closing gaps is itself normalisation. The whole band can move up while retaining a larger gap. But the repo rate cannot be raised unless the MPC moves into a neutral stance. But VRRR and other instruments aim towards smoother liquidity management so that rates stay in a small gap.

Q. Can reverse repo can be hiked while maintaining an accommodative stance?

Yes, as long as it is towards normalisation. Some of the exceptional measures can be reversed even if the stance is accommodative. The normal relationship between the repo and reverse repo can be restored even in an accommodative stance.

Q. Under what circumstances do you think the accommodative stance can be changed to neutral?

That is when MPC views that the output gap is closed and demand pressures are affecting inflation.

Q. You said, “Although household inflation expectations are naive and much in excess of realised inflation, the direction of change is instructive.” Are you highlighting the upside risk to inflation and indicating the need for action, if not now but in the near future?

No, I argue the uncertainty associated with households’ inflation expectations, which rose since March 2020 at the onset of Covid-19. All the three surveys, two expectations – three month and one year – and [inflation] perception rose recently in the middle of the second wave. Last time, after the first wave, the perception first flattened, then fell, and after a few months expectations fell. This pattern could repeat with the second wave. As households’ see current inflation reducing, their expectations will also fall. That is what I expect. Therefore, it is necessary to watch the figures for some more time.

Q So you are not worried about this persistent high inflation because you see it as transient...

I think we don’t know yet if it is persistent. That is the broader point I made in the MPC minutes. You see some rise in inflation because of supply shocks. Bottlenecks due to the pandemic raised inflation—but this is transient, even oil price inflation. We need to find out if there are second round effects that would make it persistent. But you don’t yet see signs of that. It is becoming clear the rise in international inflation is temporary. Indian inflation has also softened.

Q. Do you see the repo rate rising by the end of the current financial year?

I don’t want to make such a prediction. As we said in the statement, we are watching different aspects of the data, forward looking indicators as well as the realised outcomes. If we see growth is booming, inflation is rising then you need rate action. If there is a third wave and growth falls, unemployment is large then you continue to stay accommodative. So, it depends on outcomes.

Q. One MPC member opined that RBI appears to be targeting 5 per cent inflation. Is there a risk that a significant part of the market participants also starts believing in that, which could result in inflation expectation moving higher?

I don’t think so. Because RBI is not targeting 5 per cent inflation at all. It is targeting 4 per cent with a band of +/- 2 per cent. All it has said is that its current projection of inflation by next year is 5 per cent. That projection has a large band of uncertainty. This is its forecast, and not its target. You cannot confuse a forecast with a target. The target remains 4 per cent. In the current situation when you are just recovering from a pandemic, we don’t know whether there will be a third wave, it would be very hawkish to say if inflation is above the projection of your target then raise your rate. But it is not wise to be such an inflation nutter. As long as inflation projections are within the tolerance band, you don’t have to tighten rates as yet.

Q. Why do you think the August RBI inflation forecast of 5.7 per cent may be an overestimate?

The question is whether you see the higher inflation is due to higher demand or supply bottlenecks. My view is it is largely due to transient supply bottlenecks. Already we are seeing some reversals. Oil prices are also softening, that will percolate into Indian inflation also. I think you could see more of a reversal. The sharp rise in inflation in May and June led to arise in the RBI forecast. But this has large uncertainty bands. If oil prices fall, or taxation is reversed, or other supply side bottlenecks ease, inflation can fall. Also, May and June were the period of peak second wave when there were many lockdowns that have now eased.

Q. You have said indirect taxes impart persistence to inflation, and could de-anchor inflation expectations and pose challenges for monetary policy. Do you think the RBI policy instruments are becoming inadequate at tackling inflation?

It is not that they are inadequate. It is a question of allocation of the correct instrument to the target—using the instrument that affects the target most efficiently and with least cost. If it is supply side kind of inflation and you tighten interest rate then that will have a high output cost. We are in the beginning of an inflation targeting regime, it's not been too many years since it started. But people know if inflation is not within the tolerance band then action will be taken so they do not expect inflation to rise above that. This anchoring of expectations is one of the strengths of inflation targeting. This makes inflation shocks transitory so monetary policy can look through them. If, however, when international oil prices fall, taxes are raised but when they rise taxes are not reduced then this imparts an upward bias to these prices, which may create persistence in inflation and affect household expectations. That makes the inflation targeting more difficult.  If taxes are allowed to fall the shock becomes transient and we can look through the spike in oil prices. The idea of the reform of the oil prices was that it was no longer administered. Internationally prices rise and fall. Indian prices should also be allowed to do that.

Q. Do you think reverse repo should be a remit of the MPC?

The mandate of the MPC is decided in the Parliament and is enshrined in the RBI Act. The law does not allow MPC to vote on the reverse repo. This law is not going to change at present. With a fixed gap between them, if the MPC sets the repo, the reverse repo automatically changes. That is why it was there in the MPC resolution. But now in this exceptional time, the gap between the repo and reverse repo was changed [at the start of the pandemic].

Q. Should it be mentioned in the MPC statement?

There is no harm in it staying there since the distance between the two is fixed in normal times. In these exceptional times the special circumstances could be noted. Moreover, advanced economies under quantitative easing maintain liquidity in surplus. If in India also we operate with some surplus liquidity for some time, the repo rate could stay the operative rate and must then be in the MPC statement.