Value of liquidity

The Reserve Bank of India (RBI) will make its quarterly assessment of the macroeconomic situation next week and, consequent upon that, announce its monetary policy stance for the quarter. Last time around, in January, the RBI took many people by surprise by raising its benchmark reverse repo rate by 25 basis points for the second time in succession. There was, of course, enough justification for the increase, what with the higher than expected numbers on GDP growth and the undeniable upward creep in inflation. However, the concerns about tightening liquidity being further aggravated by the move materialised over the last few weeks. The housing finance companies collectively raised their prime rates by 50 basis points, evoking fears about a slowdown in lending in a sector which has been such an important contributor to growth in recent years. At the end of March, a group of CEOs of large banks met the RBI governor, with the anticipated outcome being some measures to infuse liquidity into the system. Reports about the meeting suggested that the RBI was rather lukewarm to their suggestions.

Subsequently, however, there has been a noticeable easing of the liquidity situation, which suggests that the RBI did not take the bankers' views lightly. In particular, there has been a sharp jump in foreign exchange reserves, which crossed the $150-billion mark for the first time, reflecting significant purchases by the central bank after a relatively long time. This has fed into the system, apparently serving to moderate the pressure and allay fears of surging interest rates smothering the growth momentum. Given the situation on this front and the fact that wholesale price inflation has been somewhat lower in recent weeks than it was prior to the January announcement, there is hardly any case for the RBI to continue with its recent pattern of rate increases.

In fact, a reversal of position might be warranted, not so much through reverse repo rate reduction but a cut (even if temporary) in the cash reserve ratio, which would immediately free some bank resources for lending. A couple of weeks ago, this might have seemed the most appropriate, and likely, response, but more recent developments have reduced the pressure to do this and the RBI is much more likely to persist with the status quo. Having said this, it cannot be denied that monetary policy has become a far more complicated exercise today than a mere couple of years ago. Dealing with the simultaneous occurrence of domestic demand pressures with the persistent threat of global oil prices is challenging enough. Add to this the exchange rate policies of close competitors and the US Federal Reserve's changing perceptions about the appropriate level of their benchmark federal funds rate and the environment becomes enormously murky.

Under the circumstances, it would be appropriate for the RBI to lay out a few likely scenarios for the coming year and what its policy responses would be in each of them. One drawback of the increase in the frequency of the policy announcements is that markets pay excessive attention to each episode and perhaps lose sight of the longer-term picture. It is for the RBI to place each quarter's measures very sharply in the context of more medium and long-term drivers of macroeconomic behaviour.