Bond market message

Conducting monetary policy will become more challenging

The Monetary Policy Committee (MPC) in its last meeting for the fiscal year this week is expected to examine the implications of the recently presented Union Budget, among other things on monetary policy in the coming quarters. Evolving conditions suggest that conducting monetary policy in the next fiscal year will be far more challenging. Bond yields have moved up sharply since the presentation of the Union Budget. The yield on the 10-year benchmark bonds, for instance, has gone up by 20 basis points. The Reserve Bank of India (RBI) rejected bids for part of its bond auction on Friday, which suggests the markets have moved ahead of its expectations.

Bond yields are rising due to a variety of factors. The most immediate reason, of course, is higher than expected government borrowing. The Union government is expected to borrow Rs 11.19 trillion from the market against the current year’s revised estimate of Rs 7.76 trillion. Besides the level of the fiscal deficit, market borrowing would go up because the government expects a lower inflow into small savings schemes. Bond investors clearly believe it will be difficult for the markets to absorb this level of supply. States are also expected to run higher deficits, which will put more pressure on yields. Further, the normalisation of liquidity conditions is also pushing up the cost of money. Financial conditions are tightening globally as some of the large central banks, including the US Federal Reserve, are reversing excess policy accommodation. Managing the government borrowing programme would thus be significantly more difficult for the RBI in the next fiscal year.
 

The central bank will not be in a position to provide the kind of support it did since the outbreak of the pandemic. If the RBI decides to extend support to contain bond yields by either slowing or reversing the normalisation process, it would increase inflation risks and affect market confidence. This could also lead to a higher capital outflow. Aside from government finances, the evolving inflation conditions would also put pressure on the cost of money. Crude oil prices, for instance, have gone up by over 20 per cent since the beginning of 2022 and may remain elevated in the near term. While the inflation rate based on the consumer price index is within the tolerance band, though significantly above the target of 4 per cent, the wholesale price inflation rate is running in double digits. As large central banks have accepted that global inflation is not transitory, the MPC would also be expected to review its position more objectively. 

Market conditions clearly suggest that the central bank is behind the curve. It is worth highlighting in this context that since liquidity is in surplus, the operating rate is the reverse repo rate. The RBI would be well advised to quickly normalise the policy corridor. As things stand today, market interest rates are likely to move up further and would soon get reflected in retail loans. Besides government finances and inflation, the MPC will also be expected to deliberate on the introduction of the central bank digital currency in the next fiscal year as announced in the Union Budget. Although details are yet to be worked out by the RBI, the launch of a digital currency can have significant implications for monetary policy.