Tentative beginning

RBI's position is still fraught with risks

As widely expected, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) left the policy rate and stance unchanged on Friday. However, the resolution of the rate-setting committee and comments by Governor Shaktikanta Das have given an impression to many in the financial markets that the central bank has made a tentative beginning towards normalisation of liquidity and monetary conditions. There were two important signals in this context. First, Jayanth Varma, an external member, did not vote in favour of the resolution to continue with the accommodative stance as long as necessary. Second, the RBI intended to increase the amount of liquidity absorption under the variable rate reverse repo window, which was held in abeyance because of the pandemic, and reintroduced in January this year.

Financial markets expect this move to affect liquidity, which has resulted in the hardening of bond yields, albeit only marginally. The RBI, however, insisted that it should not be seen as a reversal of policy accommodation. Clearly, the central bank doesn’t want any disruptive signal for the markets at this stage. There is still a risk of another wave of Covid-19, which could weaken the ongoing recovery, and the RBI would prefer to maintain the support through monetary accommodation. However, this policy position is also fraught with risks. The inflation rate, based on the consumer price index, is running above the tolerance band and has forced the MPC to revise its full-year projection. It now expects an average inflation rate of 5.7 per cent in the current fiscal year, compared to the previous estimate of 5.1 per cent. This means inflation will remain significantly above the RBI’s target of 4 per cent. In fact, if the actual inflation outcome is marginally higher than the projected rate, India will have above 6 per cent inflation for two consecutive years.
 

It has been argued that the average inflation rate at 5.7 per cent in the current fiscal year will be an improvement over the 6.2 per cent last year, and it will be brought down by spreading the disinflation process over the next two-three years to reduce the loss in output. There are at least two issues here. First, what happens if the inflation outcome is above the projected rate. Inflation has surprised the central bank on the upside — the latest revision in projections being a case in point. Also, the central bank believes that inflation is being driven by supply-side issues. Second, how will this stated disinflation process move forward? The banking system currently has very high levels of liquidity, which is unlikely to help. The daily absorption of liquidity by the RBI under the liquidity adjustment facility is about Rs 8.5 trillion.

The central bank seems to have made a hesitant beginning towards normalisation, but it remains to be seen how it moves forward without creating dislocations in financial markets. A significant delay in addressing inflation risks can increase the cost of containing it in the medium term. A sustained higher inflation rate will affect expectations and dent the credibility of the central bank. Besides, real negative interest rates for too long can affect household financial savings. Recent data suggests that small investors are increasing their investment in the stock market, partly because of negative real rates, and may end up hurting themselves. The central bank will need to find the right policy balance soon.