Tough balancing act

RBI has a difficult task of meeting multiple targets

The Reserve Bank of India (RBI) continues to be diligent in its approach of doing the heavy lifting for the economy. Since consumer price inflation has been running above the tolerance band of the central bank for several months, the newly constituted monetary policy committee (MPC) has rightly decided to leave the policy rate unchanged. However, after the monetary policy review meeting on Friday, the RBI announced several measures to improve liquidity and bring down market rates. On its part, the MPC decided to look at the current inflation bump as transient and was of the view that it was more urgent to revive growth. The commentary accompanying the policy decision was markedly different from the minutes of the August policy meeting. It is possible that the view changed because of improved understanding of economic conditions.

It is obvious that the MPC will not be in a position to cut the policy rate in the near term. The central bank’s first forecast since the outbreak of the pandemic showed that inflation would come down to 4.3 per cent in the first quarter of the next fiscal year. Inflation in the second half of the current fiscal year is likely to be at 5.4-4.5 per cent. The central bank expects that a progressive opening up of the economy will mitigate supply constraints. However, there could be risks to this assumption. It is possible that a sizeable number of small units in the unorganised sector went out of business during the nationwide lockdown and might not come back soon.

The central bank expects the economy to contract by 9.5 per cent in the current year. While some of the high-frequency indicators are showing encouraging signs, it would be important to see if the pick-up can be sustained. In this context, the RBI seems willing to go to the extent possible to support economic activity. For instance, it rationalised the risk weightings for housing loans, and that is expected to bring down lending rates. Further, it introduced on-tap targeted long-term repo operations worth Rs 1 trillion with tenor of up to three years. This will help ease rates in the corporate bond market. In line with the monetary policy stance, the RBI will maintain a comfortable liquidity in the system and has decided to increase the size of open market operations (OMOs).

Besides, the central bank for the first time decided to start OMOs in state government bonds. The idea is to enhance liquidity in this market and improve the absorption capacity for government bonds in the current year. While the bond market welcomed the decisions, there are limits to what the central bank can attain in the given circumstances. For example, final aggregate government borrowing can still change significantly. Further, the RBI’s decision to intervene in state government bonds will help increase liquidity in this segment but may not move the needle much at the aggregate level. Since buying such bonds will add to the liquidity in the system, it will curtail the scope for intervention in central government bonds. Required intervention in the currency market would also push up liquidity. Sustained excess liquidity in the system could pose risks to the RBI’s inflation forecast. The central bank is being expected to accomplish multiple objectives in areas such as growth, inflation, government borrowing, and currency management. That will be a tough balancing act.