Cautious optimism

In a situation of creeping retail inflation — at 7.6 per cent in October — it was only to be expected that the Monetary Policy Committee (MPC) would hold rather than cut the repo rate. Yet, the MPC has done well — given its inflation-targeting mandate — to persist with an accommodating stance in an effort to boost growth, possibly ruling out drastic actions on the liquidity management front to contain inflation. The MPC has acknowledged that inflation has persisted, contrary to its expectations. Yet, it expects much of this to abate over the next two quarters — falling below the crucial 6 per cent mark in Q4 — in the hope that supply-side disruptions will sort themselves out. The MPC’s hopefulness on the growth front has prompted it to revise its forecast for FY 21 to minus 7.5 per cent, from minus 9.5 per cent two months back. The message is clear to the financial sector — that it must continue to push credit across sectors, making full use of the emergency credit window as well as the term repo window.

The MPC is also operating in a unique environment, where unabated capital flows have created a mismatch between the bond market rates and the repo rates. The RBI has accumulated $100 billion in forex reserves this fiscal, a situation that, as SBI Research points out, marks a throwback to FY2008. The accretion is on account of the RBI’s efforts to keep the rupee from appreciating by mopping up dollars, as a report in this newspaper on November 30 pointed out. However, this has resulted in the short-term bond market yields falling below even the reverse repo rate of 3.35 per cent, while the long-term yield rules at nearly 200 basis points above the repo rate of 4 per cent. This disparity is despite the fact that the RBI has kept the long end of the curve down to cater to the Centre’s expanded borrowing programme. It has deployed the liquidity-neutral Operation Twist programme, selling short-term paper and buying long-term ones, to manage rates at the long end of the curve. A steep yield curve, with low short-term rates, could encourage speculative behaviour. The RBI should be aware of this possibility.

If it chooses to soak up excess liquidity (in the region of ₹6 lakh crore), it can either allow the currency to appreciate, or mop up dollars and sterilise the extra rupees through ‘market stabilisation bonds’, as attempted some two decades ago. The former is not a good idea, as it can hurt exports. In sum, it is not an easy task to maintain financial stability, while pushing growth — a lesson that central banks learnt in the run-up to the Great Financial Crisis of 2008.