RBI facing monetary policy dilemmas

First, despite the brave face in the statement, the fine print indicates that both the inflation and the growth outlook are worrying. RBI’s own expectation of consumer price inflation is above 5% and very close to the upper limit of the 6% tolerance level. Domestic expectations are quite high. The inconvenient truth is that growth, investment and employment have yet to revive beyond low pre-pandemic rates, and we could be entering inflationary territory.

Second, the risk of a reversal in US Federal Reserve policy increases soon after the Fed chair’s Jackson Hole speech and the recent Federal Open Market Committee announcements. Inflation has consistently exceeded the Fed’s forecasts, even though growth has been strong. economists such as John B. Taylor, author of the ‘Taylor Rule’ named for monetary policy, and wall street journal The persistence of near-zero (nominal) policy rates under the current Fed Chair was described by Arthur C. Burns, whom history has blamed for igniting the great inflation of the 1970s. If inflationary pressures do not ease, the Fed will be forced to act.

The Federal Reserve and the RBI face similar dilemmas, but only up to a point. Both have continued to drive negative real interest rates to propel growth, adding to inflationary pressures. Both have been able to keep bond yields from rising through aggressive market intervention and expansion of their balance sheets, which has fueled the stock market’s rally.

A closer 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 in the primary market are funded by the RBI through buybacks in the secondary market, (it is no longer allowed to be taken directly from the Treasury), i.e. its balance sheet through the expansion of. Liquidity adjustments are managed through repo and reverse repo operations on a day-to-day basis. RBI’s recent initiative to retail government securities directly to individual investors is an indication of its intention to continue with its bond purchases. Therefore, it may persist with a lenient monetary policy longer than market participants expect.

The Fed can survive with almost zero lower bound rates because it has the ‘extreme privilege’ of dealing with the global reserve currency for which there seems to be an immeasurable appetite. Its monetary policy drives the global financial cycle and cross-border capital flows. Other countries, especially emerging market and developing economies such as India, copy the Fed at their own peril as they risk a market revolt.

The Fed, moreover, may take a more benign view of inflationary pressures because it has a dual policy goal that gives equal weighting to growth and inflation. It sees the current inflationary pressures as transient and expects them to ease with the opening up of the supply chain pressure.

Inflation, on the other hand, is the RBI’s primary policy target, with price stability “an essential precondition for sustainable growth”. Like the Fed, the RBI considers inflationary pressures to be transient. But economists and market participants worry that if inflationary pressures persist, both central banks will be forced to reverse policy and raise rates.

Unlike the Fed, which faces an overheating economy, the RBI finds itself between a rock and a hard place, with growth staying below trend. It transfixed like a deer in the headlights of a car at night, unable to decide whether to lower or raise rates. There is no monetary policy solution to stagflation. Raising rates will not help as inflationary pressure is on the supply- not the demand side. Pumping more easy money to stimulate growth will only lead to inflation and asset prices still higher.

However, there could be no escape for the RBI if it was confronted with the trident arising from the reversal of US monetary policy. Unlike China and many other Asian countries, India’s foreign exchange reserves are not the result of accumulation of trade surplus. India runs a structural current account deficit that needs to be financed through capital inflows. Its forex reserves have been built on the back of a Fed-induced global financial cycle, which has sent a flood of capital into emerging markets in search of higher yields, as the Fed has kept US interest rates at zero limits for an extended period. Period through continued expansion of its balance sheet.

If this cycle turns, India could deplete foreign exchange reserves and the central bank would be forced to raise rates to maintain macroeconomic stability. Rising fuel prices will make the situation worse. Based on comparative current macroeconomic indicators, the ‘taper tantrum’ experience suggests that India could be one of the most affected emerging markets. In such a situation, RBI may be forced to take action.

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