Against the backdrop of mounting global uncertainties emanating from war in Ukraine and the energy price volatility, RBI has taken a smart move to go hawkish, by tightening the liquidity in Indian economy.
In the recent Monetary Policy Committee (MPC) deliberations in April 2022, all the MPC Members voted for “pause” in the revisions of policy rates. The policy rates are left untouched. The repo rate is kept status quo at 4 per cent. The reverse repo is maintained at 3.35 per cent. The Marginal Standing Facility (MSF) -which is the overnight rate for parking the liquidity with RBI – is kept status quo at 4.25 per cent.
It was an interesting move by RBI by simultaneously keeping the policy rates unchanged and introducing a new toolkit – Standing Deposit Rate (SDF) at 3.75 per cent – to absorb excess liquidity. However, SDF is not a post-pandemic innovation in monetary policy stance. In Urjit Patel Committee recommendations, SDF was suggested to absorb excess liquidity, by curbing the tendency of the banks to invest above Statutory Liquidity ratio (SLR) in government gilt-edged securities.
The monetary policy corridor – the space between the reverse repo rate and the MSF – is re-calibrated by introducing this new instrument SDF at 3.75 per cent, to absorb the short term excess liquidity in the system.
As part of the economic stimulus package “AtmaNirbhar”, the fixed reverse repo rate (FRRR) was kept status quo at 3.35 per cent since May 2020 to “nudge” the commercial banks not to park back in RBI. However, with the new tool SDF, the FRRR has become redundant. RBI has engaged in subtle normalization process through variable reverse repo rate (VRRR) whose cut off yield rate has been 3.99 per cent. The earlier than expected normalization process has become important against the backdrop of mounting inflation and global macroeconomic uncertainties. The normalization process is crucial as the call money rates have been below the repo rate for long time. The long term bond yield curve has also shown sufficient volatility.
The RBI has surprised the markets by this strong move towards policy sequencing of inflation containment prior to economic growth in the recent MPC meetings. Since May 2020, indeed the policy imperative of RBI has been “whatever it takes” to tackle the economic growth recovery process. However, with the war in Ukraine and mounting inflationary pressures, price stability has become the significant concern for RBI. The ever-mutating coronavirus would continue as a crucial determinant of macroeconomic uncertainties.
Instead of SDF, had Reserve Bank of India been hiking the repo rates to contain inflationary pressures, the growth recovery process could have slowed down, as the credit would have become expensive. At the same time, keeping the status quo on policy rates for a prolonged period can catalyse the de-anchoring of inflationary expectations. In the next MPC deliberations, my hunch is a plausible rate hike is on board, given the mounting inflation. The global financial markets have turned volatile due to the US Federal Reserve’s potential rate hike series, indicating huge capital flight – of hot money. A potential rate hike is crucial to pre-empt the capital flight.
The financialisation of savings are affected with low policy rates, given the mounting inflation. The zero lower bound of real rates of interest and even the negative real rates of interest are matters of urgent concern. The RBI Governor in the press meetings after the MPC deliberations clarified that central bank will seriously examine the repercussions of negative real rates of interest on the economy and take adequate steps required.
The accusation that “RBI is behind the curve” has been responded with the brilliant re-calibrations for tightening the liquidity. However, the MPC projections of inflation (5.7 per cent) is a close touch towards the upper bound of the mandated band at 6 per cent. If RBI fails to control the inflation within the new monetary framework (nmf) mandate of 6 per cent in three consecutive quarters, then the efficacy of inflation targeting framework – in anchoring the inflationary expectations – will be at stake. When inflation is rising, a slower monetary policy tightening by RBI could accelerate the de-anchoring of inflation expectations. The RBI might “bite the bullet” by hiking policy rates in the next MPC meetings. However, such moves can affect the public debt management as the cost of borrowings will go up with the hikes in interest rates. The potential hike in interest rates can also affect the economic growth recovery process. The MPC has projected the growth path only at 7. 2 per cent. This is way behind the projections in the Economic Survey by the Government of India to above 8 per cent for this fiscal. Given this policy dilemma on monetary policy stance, a conscious fiscal policy package is crucial to pre-empt the adverse impacts on growth recovery of exogenous supply shocks. The existing fiscal space constraints can deter the government from reducing the fuel taxes. At the same time, a series of hikes in fuel taxes can affect the disposable income in the hands of people in a pandemic-ridden economy.
Further a deliberate policy co-ordination between monetary and fiscal authorities is crucial to arrest the mounting inflation emanating from energy price volatility, restricted trade movements and delays in consignments, and supply chain disruptions. The acknowledgement by RBI that current inflationary phenomenon is not “transient” itself is a bold first step.
Lekha Chakraborty is Professor at National Institute of Public Finance and Policy and member of Governing Board of International Institute of Public Finance, Munich.