Remember the time in school when your neighbor made a noise, but the teacher retaliated and punished you. This is how the fiscal dominance of monetary policy feels. The significant gross borrowing announcement made by the Union Budget in the context of a massive jump in capital spending has turned the bond market upside down and prompted the Reserve Bank of India (RBI) to look at how this borrowing is handled. . will be absorbed. Yields on 10-year government bonds have jumped since the budget.
Certainly the timing was not good for RBI. Through the pandemic, it has avoided reacting to high inflationary pressures – attributing them to temporary factors – and has remained focused on growth. This has prompted expansion of the 25 basis point (bps) repo-reverse repo rate corridor to 40 bps, keeping the policy repo rate record low and injecting liquidity through its quantitative easing programme. All these were ripe conditions for an elaborate government lending programme, with the intervention of the RBI in sync with its agenda of easier financing.
However, these circumstances have now gone to their heads. Growth has returned to normal at pre-pandemic levels. Even though the RBI has tried its best to ease inflationary pressures, the uncomfortable reality is that consumer prices are currently about 12% higher than they were before the pandemic. There is a risk that consumer price index (CPI)-based inflation could average 6% year-on-year (y-o-y) this year, with higher global commodity prices, and firms raising prices. Meanwhile, the Federal Reserve is set to raise policy rates by up to 150 bps in our view (with the potential for a 50 bps hike at the March meeting), citing a much less hospitable global environment.
In our view, we have reached a juncture when it is pertinent to ask what ultra-accommodative monetary policy can achieve for growth, especially under the aegis of expansionary fiscal policy. And, is the loss of credibility of the central bank to fight inflation justified? After all, ignore inflation for too long, and ironically you risk growth, as inflation affects the bottom half of the household pyramid the most.
This change of winds has been silently accepted by RBI. It has closed with its quantitative easing. Without changing the fixed reverse repo rate, it has shifted the focus of its liquidity absorption operations to the variable reverse repo rate (VRRR), where the auction takes a cut-off closer to the repo rate, effectively eliminating the traditional reverse repo rate. gives. Without fiscal dominance, the ‘usual’ route to hyper-accommodative monetary policy is to first narrow the traditional policy corridor, then reduce sustainable liquidity from money markets. Thereafter, change the policy stance from accommodative to neutral, and then begin with a hike in policy rates.
However, heavy government borrowing amid high credit growth complicates this arithmetic. For example, the RBI cannot infuse liquidity from open market operational sales of bonds while the market is struggling to absorb government borrowings. How RBI plans to get its feet on both boats will be seen in its February policy meeting. We expect this to assure that the lending program will be conducted without disruption, and possibly suggest counter-balancing tools to limit the impact on liquidity.
However, allowing expansionary fiscal policy to compromise the RBI’s priorities on policy normalization could be a costly mistake. So, while we expect the Monetary Policy Committee to vote unanimously to keep the policy repo rate unchanged and 5-1 to maintain its accommodative stance, we expect the reverse repo rate to rise by 20 bps. There will be a ‘formal’ partial improvement up to 3.55%. and guidance on tools for normalizing durable liquidity.
Finally, we believe that the time has come for liberal monetary policy. In our view, the RBI will hike rates by 100 bps in 2022, and the hiking cycle may begin as early as the April meeting. So far, however, the RBI has shown little appetite for it – its stance remains ‘accommodative’ and even the most staunch MPC member, Jayant Verma, argued in the last policy meeting that the 4% The repo rate was reasonable.
However, to quote RBI Deputy Governor Michael Patra, “…we prefer a looser and transparent transition – glide path rather than crash landing. If so, we believe it is a good time to announce now.” It’s time we got clearance to take-off and buckle up. Our seat belts. Whether RBI goes to the runway, or continues to taxi around in the circle, in our view, the February policy meeting will continue to be the biggest cliff hanger .
Aurodeep Nandi is the Vice President, Economist of India at Nomura.
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