Home / Opinion / Columns /  Control tower to RBI: Are we cleared for take-off?

Remember the time in school when your neighbour made a noise, but the teacher turned around and punished you instead. Fiscal dominance of monetary policy feels something like that. For all the noise that the Union budget made in terms of a large ramp-up in capital spending, it’s the significant gross borrowing announcement that led the bond market to turn around and look at the Reserve Bank of India (RBI) on how this borrowing would be absorbed. The yield on the 10-year government bond has surged since the budget.

The timing admittedly wasn’t great 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 led to it expanding the 25 basis points (bps) repo-reverse repo rate corridor by 40 bps, keeping the policy repo rate at a record low, and injecting liquidity through its quantitative easing programme. All of these were ripe conditions for an expansive government borrowing programme, with RBI’s intervention in sync with its agenda of easy financial conditions.

However, these conditions have turned on their head now. Growth has continued to normalize back to pre-pandemic levels. Even though RBI has tried its best to downplay inflationary pressures, the uncomfortable reality is that consumer prices are currently almost 12% higher than they were before the pandemic. There is a risk that Consumer Price Index (CPI)-based inflation could average close to 6% year-on-year (y-o-y) this year, with higher global commodity prices, and firms raising prices. Meanwhile, the Federal Reserve is all set to hike policy rates by as much as 150 bps in our view (with a 50 bps hike likely at the March meeting), making for a much less hospitable global climate.

In our view, we have reached that inflection point, when it’s valid to ask what further ultra-accommodative monetary policy could achieve for growth, especially under the aegis of expansionary fiscal policy. And, is the loss of central bank credibility of fighting inflation worth the cause? After all, ignore inflation too long, and ironically, you jeopardize growth, as inflation affects the bottom of the household pyramid the most.

The RBI has tacitly admitted to this change of winds. It has stopped 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 auctions carry cut-offs close to the repo rate, effectively nullifying the conventional reverse repo rate. Without fiscal dominance, the ‘normal’ route out of ultra-accommodative monetary policy is to first narrow the conventional policy corridor, then reduce durable liquidity from money markets. Next, change the policy stance from accommodative to neutral, and then start with policy rate hikes.

However, heavy government borrowing amid higher credit growth complicates this arithmetic. For example, RBI cannot reduce liquidity by open market operation sales of bonds, while the market is struggling to absorb government borrowing. How RBI plans to keep its feet on both boats will be keenly watched at its February policy meeting. We expect it to assure that the borrowing programme will be orchestrated without disruptions, and possibly suggest counter-balancing tools to limit the impact on liquidity.

However, allowing expansionary fiscal policy to compromise RBI’s priorities on policy normalization may be a costly mistake. So, while we expect the Monetary Policy Committee to vote unanimously to keep the policy repo rate unchanged and a 5-1 vote to maintain its accommodative stance, we expect a ‘ceremonial’ partial correction of the reverse repo rate by 20 bps to 3.55% and guidance on tools to normalize durable liquidity.

Finally, we believe that the time’s up for accommodative monetary policy. In our view, RBI will raise rates by 100 bps in 2022, and the hiking cycle could start as early as April’s meeting. So far, however, RBI has shown little appetite for this – its stance remains ‘accommodative’ and even the most hawkish MPC member, Jayanth Verma, has argued at the previous policy meeting that a repo rate of 4% was appropriate.

However, to quote RBI deputy governor Michael Patra, “…we like tepid and transparent transitions — glide paths rather than crash landings". If so, we believe now would be a good time to announce that we are cleared for take-off and buckle our seat belts. Whether RBI heads to the runway, or continues to taxi around in circles, will remain the biggest cliff hanger of the February policy meeting, in our view.

Aurodeep Nandi is India economist, vice-president at Nomura.

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