Policy dilemma

Central banks must focus on inflation

The inflation rate based on the consumer price index once again remained above the upper end of the Reserve Bank of India’s (RBI’s) tolerance band in February. Pushed up by higher prices of cereals and milk, among other things, the rate in February came at 6.44 per cent, marginally lower than the 6.52 per cent in January. The headline rate has thus remained above the 6 per cent mark for 12 out of the past 14 months. Given the inflation outcomes, the Monetary Policy Committee would need to revisit its projections. The committee was expecting an average rate of 5.7 per cent in the ongoing quarter, which now looks unlikely. A revision in the inflation outlook would also have implications for policy-rate decisions.

The rate decision, however, may not be as straightforward for the RBI, or any other central bank for that matter, after what happened in the US banking system in recent days. A sudden and sharp increase in interest rates by the US Federal Reserve, leading to substantial erosion in the value of the investment portfolio of banks, mainly government bonds and mortgage-backed securities, partly fuelled the problem. According to one estimate, the unrealised losses on such holdings were in excess of $600 billion in December 2022. As the policy rate has increased further, it is likely that such portfolios are now worth less than what they were in December. The value would erode further if the central bank keeps increasing interest rates to fight inflation. While the Fed has found a way to deal with the immediate problem, it is not a sustainable solution. It is lending to eligible institutions against US treasuries and some other instruments at par. This will help financial institutions address immediate liquidity issues, but not solve the underlying problem.
 

Financial markets are now betting that the Fed would go slow in terms of raising interest rates, which led to a rally in the bond market — it was also partly driven by risk aversion in the system. Notably, last week markets were factoring in the possibility of a steeper rate hike after Fed Chairman Jerome Powell noted the eventual level of the interest rate might be higher than what was expected earlier. While the Fed’s actual stance will be known on March 22, financial-sector instability is likely to pose a dilemma. Should it focus on its fight against inflation or protect financial stability? The US inflation rate for February came at 6 per cent. Most central banks that have been raising interest rates, including the RBI, would face a similar dilemma even if there are no immediate financial-stability risks.

While the problem has arisen partly because most central banks were behind the curve in their response to higher inflation, in principle, there is no real trade-off. Central banks should focus on containing inflation because the longer-term cost of not doing so, which can affect expectations, would be much higher and pose a far bigger threat to financial stability. The immediate risk to the financial system can be addressed by analysing potential portfolio losses of financial institutions and making sure they are adequately capitalised. Central banks should also be prepared to extend liquidity support. While the bank balance sheet in India has improved significantly over the last few years, a continuous evaluation of banks and other financial institutions would allow the RBI to focus on attaining the objective of price stability.