Beyond the rate decision

RBI will have to address the excess liquidity issue

The interest rate decision will be relatively easy for the Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC), which will meet this week to review the policy. No one in the market expects the rate-setting committee to touch the policy rate, and the reasons for maintaining a status quo are fairly clear. The consumer price inflation rate has been running above the target band of the central bank for months. In normal circumstances, it would have perhaps warranted a tightening. Retail inflation was at 7.6 per cent in October. But at a time when output is contracting, the MPC is expected to support economic activity and maintain monetary accommodation.

However, both the MPC and RBI will need to address issues that would affect policy choices in the near to medium term. For instance, it was argued that supply-side disruption because of Covid-related restrictions on movement was pushing up prices. But restrictions have been eased and economic recovery in the second quarter was faster than expected. Thus, it is possible that other factors are driving inflation and it will remain elevated in the coming months. The central bank would need to revise its inflation forecast along with growth projections for the year. It was expecting the inflation rate to come down to 5.4-4.5 per cent in the second half of the fiscal year, which now looks unlikely. Although liquidity management is not within the purview of the MPC, it would do well to deliberate whether the excess of it is having an impact on inflation outcomes. Excess liquidity in the system is over Rs 6.5 trillion and short-term market rates have slipped below the reserve repo rate. This can affect the standing and credibility of monetary policy with longer-term implications.

The RBI will need to review its stance on liquidity as the economy recovers. Part of it would be addressed as the emergency cut in the cash reserve ratio will be automatically reversed at the end of the current fiscal year. But this would not be enough. Besides, the RBI’s intervention in the currency market to absorb the excess inflow of foreign exchange, which is a big driver of domestic liquidity, is likely to continue. Although imports are expected to improve as the economy recovers, India will still see a significant balance of payments surplus in the foreseeable future because of strong capital flows. Since the RBI cannot pull out of the currency market and let the rupee appreciate significantly, which will affect India’s external competitiveness, it should evaluate other ways of addressing excess liquidity. One option could be to review the inflow of debt capital. It can also look at ways to encourage the outflow of foreign exchange. Further, at some point, in consultation with the government, it could consider options such as market stabilisation bonds.

However, all this will need to be done carefully to ensure that it doesn’t result in an abrupt tightening of financial conditions. It is important to recognise that both the Central and state governments have large borrowing programmes. In fact, with the given liquidity situation, the government can push spending a bit and support economic activity in the current year as it would be expected to start fiscal consolidation from the next year. Overall, while the rate decision for the MPC would be relatively easy, it needs to start debating how the challenges posed by sustained higher inflation and liquidity can be addressed.