A liquidity check for monetary policy doves
While you are reading this article, the six-member monetary policy committee is huddled together to decide on interest rates and its policy stance. Demands for a rate cut have risen in the past fortnight, especially with the latest inflation print coming way below the 4% target the Reserve Bank of India (RBI) has set. The clamour for a softening of the monetary policy stance is even louder.
It needs only one look at the banking sector’s liquidity that is instrumental in keeping bond yields depressed, to dismiss the need for a rate cut. As of Monday, banks had parked an outstanding Rs4 trillion with RBI through its various liquidity windows. With no slack in government spending and the collapse in credit growth, the surplus liquidity is likely to remain so. The central bank itself had suggested that it foresees liquidity remaining in surplus for the rest of fiscal year 2018, although the surplus may reduce progressively.
Since the April policy statement, the call rate has continued to hug the reverse repo rate (which was hiked by 25 basis points), and money market rates have hardly moved up. Many banks have also pruned their lending rates sharply in response to the deluge of deposits after the note ban. In short, the central bank’s dream of transmission has come true.
Bond yields have been tricky as they have hardened by 25 basis points since the policy stance change in April from accommodative to neutral. Bonds have also given up most of the demonetisation benefits as yields are back to where they were just before the note ban. However, it should not be ignored that banks have deployed most of their demonetisation deposits in bonds. In the absence of the cash purge, bond yields would have been far higher.
Despite RBI’s hawkish statement in April, liquidity has ensured that rates don’t harden much. What the central bank needs to do is maintain a liquidity surplus that’s enough to bring down yields further. That and lowering the inflation forecast in itself would set a softer policy tone. A rate cut would be a cherry that no one would miss.