A journey towards monetary normalisation

As widely expected, the Monetary Policy Committee of the Reserve Bank of India maintained status quo in the policy rates as also in the policy stance in its fourth bi-monthly meeting this fiscal. On the face of it, the decisions as well as the wordings of its statement were identical to those of the last meeting that was held two months back. Also, while there was agreement on the part of all members to hold the repo and reverse repo rates unchanged at 4% and 3.35%, the decision to continue with the accommodative stance received one dissent, as in August.

In the aftermath of the policy release, the equity market was slightly up, while the 10-year G-sec yield moved up by about 3 basis points.

Policy Normalisation

In the run up to this bi-monthly meeting, there were expectations that the RBI would throw some hints, at least, for normalisation of the extra-loose monetary and liquidity policies being pursued since the onset of the pandemic in March last year. A view has gained ground that the risk of delaying normalisation for too long would emanate not just from the prospects of higher inflation and the RBI falling behind the curve, but also from weak spots developing in the financial system. Indeed, a view was expressed by a member of the MPC that monetary accommodation appears to be stimulating asset price inflation to a greater extent than it is mitigating the distress in the economy.

There are some crucial indications from the RBI Governor’s statements that the liquidity tap may be shutting soon

Quite understandably, the statement of the MPC stopped short of making any reference to normalisation, since any first step for this purpose should be by way of removal of excess liquidity that was injected by the RBI with a view to supporting ‘a speedy and durable economic recovery’. However, one finds clear indications of the RBI’s resolve in this regard in the Governor’s statement: ‘a near consensus view emerging among market participants and policy makers is that the liquidity conditions emanating from the exceptional measures instituted during the crisis would need to evolve in sync with the macroeconomic developments to preserve financial stability. This process has to be gradual, calibrated and nondisruptive, while remaining supportive of the economic recovery.’

Phased removal of excess liquidity would lead to money market rates rising above the reverse repo rate of 3.35% which would eventually allow the RBI to narrow the gap between repo and reverse repo rates from the present high of 65 basis points. This gap, which was 25 basis points in the pre-pandemic era, was expanded in phases, beginning with the policy announcement on March 27, 2020.

The purpose of asymmetric lowering of the reverse repo rate was to make it relatively unattractive for banks to passively deposit funds with the RBI and instead, to use these funds for lending to productive sectors of the economy. However, it is doubtful if this approach has served its stated objective. The surplus liquidity in the banking system witnessed a three-fold increase from a daily average of Rs. 3 lakh crore in March, 2020 to Rs. 9 lakh crore in September, 2021 and further to Rs. 9.5 lakh crore in the first few days of October. As per the estimation made by the RBI in this regard, the potential liquidity overhang amounts to more than Rs. 13.0 lakh crore – about 25% of the country’s GDP.

Taper steps?

One finds two announcements in the Governor’s statement that could very well be seen as two crucial ‘taper’ steps: First, a stop to the G-Sec Acquisition Programme (G-SAP) for the present. The recent healthy trend in the Central government’s revenue collection implying thereby that its market borrowing programme for 2021-22 is unlikely to see any significant upward revision has been a contributory factor here. Second, the RBI may consider complementing the 14-day variable rate reverse repo (VRRR) auctions, which is currently its main instrument for liquidity absorption with 28-day VRRR auctions in a calibrated fashion. Oddly, the RBI has vehemently cautioned that this step should not be seen as a reversal of its current accommodative stance. It’s difficult to surmise why the RBI is not ready to follow a more nuanced interpretation in this context.      

The dominant view appears to interpret the MPC’s (4 +/-2)% inflation targeting framework to mean that in the current exceptional and pandemic-ravaged time, the effective target should be 6% and not 4%. There seems to be a lack of clarity on the precise meaning and implications of the +/-2% band around 4%.

Interestingly, in the auction for 14-day VRRR that was held within hours of the policy announcement, the cut off rate was 3.99% for an aggregate bid amount of about Rs. 4 lakh crore, while the average rate was 3.65%, compared to 3.61% in the previous auction held in September. It is possible that in the weeks to come, the 14-day and 28-day reverse repo rates will be increasingly higher than the policy reverse repo rate.    

Few important developments that must have weighed in favour of the RBI’s ‘taper’ announcements, as above, are the Federal Reserve’s recent communication that the time to commence tapering of its asset purchases -so-called quantitative easing - is drawing near and the current strength of the US dollar causing some pressure on the rupee.

A debate within MPC

By all indications, an intense but very useful debate has been occurring in the MPC’s deliberations during this and the previous bi-monthly meetings, which witnessed a dissenting vote by a particular member on some aspects of the continuance of the accommodative policy stance.  The central themes of this debate appear to concern two issues: One, at this stage of the Covid-19 pandemic and given its likely progression in the future, whether continuation of extra-loose monetary and liquidity policies would result in more macroeconomic benefits than costs. Two, given the fact that the actual CPI inflation at above 5% has been consistently exceeding the 4% target, will the MPC not be diluting its mandate by prioritising growth over inflation?

Monetary accommodation appears to be stimulating asset price inflation to a greater extent than it is mitigating the distress in the economy

The dominant view on the first seems to be that the country’s GDP is still below the pre-pandemic level and, hence, there is significant slack in resource utilisation in the economy which needs to be reduced expeditiously to spur growth. There is a price for this policy choice in the form of higher inflation in the upper confines of, but within the tolerance band.  Also, ample liquidity infusion and significant interventions in the forex and G-Sec markets are necessary to ensure not only their orderly functioning but also to guide price discovery in them. As regards the second one, the dominant view appears to interpret the MPC’s (4 +/-2)% inflation targeting framework to mean that in the current exceptional and pandemic-ravaged time, the effective target should be 6% and not 4%. There seems to be a lack of clarity on the precise meaning and implications of the +/-2% band around 4%.

Like in any other situation, the dominant view will carry the day. But the debate will continue and its intellectual rigour and outcome will certainly shape the way the MPC functions and decides in future.

(The writer is a former central banker and a consultant to the IMF)