The last time the Reserve Bank of India (RBI) restrained itself from acting on excessive liquidity, it had to face a double-digit inflation rate in the years ahead.
This was the flood of liquidity around September 2009 and the years of double-digit inflation started in 2011. Granted, the situation was not so linear and the rise in inflation was not a mere ignition of demand by excess money. But there are enough history lessons to warn what excessive money can lead to.
When the monetary policy committee (MPC) begins its two-day deliberations on policy rates on Wednesday, it will in all probability not just include but highlight the current deluge of liquidity.
After all, RBI’s monetary policy stance and the impact of MPC’s decision on interest rates hinges solely on how much money should be allowed to slosh around in the banking system and for how long.
The favourite tool to suck out liquidity in the past was the cash reserve ratio (CRR). But it would be a waste to hike the CRR now as a 50 basis point increase would impound only a fraction of the liquidity surplus, which is currently a massive Rs3.5 trillion. A basis point is one-hundredth of a percentage point. CRR is also a blunt tool and it affects all banks in the same manner although liquidity is almost always skewed among lenders.
While many other tools have been discussed including a new one called standing deposit facility, what matters is that the surplus money should be impounded immediately.
Why should the central bank hurry on liquidity?
One argument is that investment demand is tepid and as credit growth is unlikely to pick up from its historic lows, there is no way surplus liquidity can fuel inflation. However, corporate bond yields are down more than 50 basis points and the benchmark equity indices have soared more than 20% in fiscal year 2016-17, a year in which corporate balance sheets were under severe pressure. These are evidences enough to show that liquidity has begun fuelling asset prices.
Leaving the surplus liquidity problem unattended would lead to money chasing yields and thereby investments into riskier assets. In its worst form, the surplus could find its way into stressed assets at an unwarranted price.
MPC voted to put an end to easing the interest rate regime in February to safeguard the medium-term retail inflation target of 4%.
This time, the vote should be for changing surplus liquidity conditions that may undermine its inflation management.