RBI faces monetary policy dilemmas


As widely expected, the Reserve Bank of India (RBI) once again left its negative real policy rate unchanged in the October 8 monetary policy announcement. The macroeconomic situation on the ground had not changed significantly during its latest policy announcements. If anything, his dilemmas have escalated.

First, despite the courageous face displayed in the press release, the fine print indicates that the inflation and growth scenarios remain worrying. RBI’s own expectation for consumer price inflation is above 5% and very close to the upper bounds of its 6% tolerance level. Household expectations are considerably higher. The inconvenient truth is that growth, investment and jobs have yet to pick up beyond the low rates before the pandemic, and we could enter stagflation territory.

Second, the threat of a US Federal Reserve policy reversal as soon as possible has increased following the Fed Chairman’s Jackson Hole speech and recent announcements by the Federal Open Market Committee. Inflation has consistently exceeded the Fed’s expectations, even as growth has been robust. Economists such as John B Taylor, author of the eponymous “Taylor Rule” for monetary policy, and The Wall Street Journal describe the persistence of policy (nominal) rates close to zero under the current Fed presidency as the most reckless since Arthur C. Burns, whom history has held responsible for triggering the great inflation of the 1970s. inflationary pressures do not subside, the Fed will be forced to act.

The Federal Reserve and the RBI face similar dilemmas, but only up to a point. Both have persisted with negative real interest rates to stimulate growth, adding to inflationary pressures. Both succeeded in keeping bond yields from rising thanks to aggressive market intervention and expansion of their balance sheets that inflated stock booms.

A careful reading of the RBI governor’s statement indicates that monetary policy is now an extension of fiscal policy. Banks and other financial institutions that buy long-term sovereign bonds on the primary market are financed by the RBI through its secondary market buybacks (it is no longer allowed to collect them directly from the treasury), that is, by expanding its balance sheet. In the three fiscal years ended March 31, 2021, RBI’s stock of government securities more than doubled from 3.7% to 6.8% of gross domestic product (GDP), of which 1% was last year alone. . During this three-year period, an additional 1.7% of GDP was paid as a dividend to the Treasury. Day-to-day liquidity adjustments are managed through repurchase and reverse repurchase transactions. RBI’s recent move to retail government securities directly to individual investors is indicative of its intention to continue buying bonds. It can therefore persist with an accommodating monetary policy longer than expected by market participants.

The Fed can persist with lower cutoff rates close to zero because it has the “exorbitant privilege” of working with the global reserve currency for which there seems to be a bottomless appetite. Its monetary policy drives the global financial cycle and cross-border capital flows. Other countries, especially emerging markets and developing economies like India, emulate the Fed at their peril as they risk a market revolt.

In addition, the Fed may have a more favorable view of inflationary pressures because it has a dual policy objective that gives equal weight to growth and inflation. He sees current inflationary pressures as transient and expects them to ease as pressure on supply chains eases as the economy opens up.

Inflation, on the other hand, is the primary policy objective of the RBI, with price stability “a necessary precondition for sustainable growth.” Like the Fed, the RBI views inflationary pressures as transitory. , the two central banks would be forced to reverse their policy and raise their rates.

Unlike the Fed which faces an overheating economy, the RBI sits somewhere between a rock and a hard place, with growth remaining below trend. He’s frozen like a deer in the headlights of a car at night, unable to decide whether to keep / lower rates or raise them. There is no monetary policy solution to stagflation. Raising rates will not help because inflationary pressures are on the supply side and not on the demand side. Injecting more easy money to stimulate growth will only push inflation and asset prices even higher.

But the RBI would have no escape if it were faced with the trilemma of a turnaround in US monetary policy. Unlike China and several other Asian countries, India’s foreign exchange reserves are not the result of an accumulation of trade surpluses. India has a structural current account deficit which must be financed by capital inflows. Its foreign exchange reserves were built up through a Fed-induced global financial cycle, which sent a flood of capital into emerging markets in search of higher yields as the Fed kept US interest rates low. zero for an extended period. period through a sustained expansion of its balance sheet.

If this cycle is reversed, India could bleed its foreign exchange reserves and the central bank would be forced to raise rates to maintain macroeconomic stability. Rising fuel prices would make the situation worse. Based on existing comparative macroeconomic indicators, the taper tantrum experience indicates that India may be one of the most affected emerging markets. In such a situation, RBI could be compelled to act.

Alok Sheel is RBI Professor of Macroeconomics, Indian Council for International Economic Relations Research

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