Home / Opinion / Columns /  The options for RBI beyond yield curve control

Central banks are in an unenviable position. Covid-19 has expanded their scope beyond mainstream policy, to not only stabilizing financial markets, but also contend with an accommodative fiscal policy, which requires a smooth passage of an extraordinary quantum of debt issuance through the markets.

The Reserve Bank of India also finds itself in a similar place. At this point, the near-term path of rate decisions is perhaps the most straightforward. India’s inflation path has diverged from regional peers, staying stubbornly above the target range +/-2% of 4% for nine quarters, owing to home-grown idiosyncrasies. September’s inflation looks set to go past 7%.

A rate pause at the October review is baked in, with our evolving trend and momentum forecast of inflation pointing to unchanged rates in December, too, notwithstanding a new monetary policy committee (MPC) that has just taken office. The new external members, with specializations in macroeconomics, financial markets and developmental economics, are likely to provide a well-rounded perspective, with the dominant leaning towards a dovish end of the spectrum, based on some of their past commentaries.

Review of the inflation-targeting framework falls due in March 2021, and we don’t anticipate any sweeping changes. Rebutting views that the targeting framework could focus on core inflation rather than CPI, a recent RBI working paper concluded that the stickiness component in food does not fully align with the core gauge. Hence, a move to purely base monetary policy decisions on core CPI might result in over or under tightening of monetary levers.

Bigger challenges lie beyond the realm of rate decisions. Policymakers find themselves on a balance beam, managing a dollar deluge, while ensuring FX stability and keeping bond yields low, just as inflation plays spoilsport. Debt markets will be the near-term priority, after a relatively placid first half of the fiscal year.

Underlying dynamics will be different in the second half, as erstwhile supportive forces run their course. Bulk of monetary policy easing is behind us, surplus liquidity is already at its peak, domestic banks accelerated their bond purchases amid weak lending activity, which has seen the statutory liquidity ratio jump to more than 10% than the required 18%, and markets have gotten ahead of themselves counting on the authorities’ implicit yield curve control (YCC), which has seen limited follow-through.

With over 75% y-o-y increase in the gross dated securities supply in 1H behind us, investors are keen to know how the second half will fare. Keeping the 2H borrowing schedule unchanged (for now) underscores the uncertainty that clouds public finances and the quantum of revenue shortfall. Odds of an increase in borrowings in early 2021 remain high. A carve-out of covid-specific securities and opening that to retail participation (with in-built tax relief) also present out-of-box options to finance the deficit. State development bond supply, which is routinely back-heavy, will add to total supply of debt. Beyond implicit YCC, debt buyers count on the central bank to stabilize bond markets via open market operations.

While pressure builds for direct debt monetization, the primary challenge is to ensure and communicate that this is a one-off pandemic-induced arrangement and not a recurrent financing line. Economies with persistent twin deficits—current account (this year’s surplus is an outlier) and fiscal deficits—come from a weaker starting point. The RBI is, thereby, likely to walk down that path only as a last resort, given the subsequent repercussions on currency and inflationary pressures from a higher monetary base, besides scrutiny by global rating agencies.

While it juggles multiple priorities, the nature of the health crisis also necessitates a strong fiscal response. First few courses of fiscal measures were timely to backstop economically vulnerable households, migrated labour and small businesses get through the lockdown. More recently, reforms in the agri sector and consolidation of labour laws and relaxation of few tax compliance norms have been pursued.

The next leg of lift might be directed at boosting purchasing power through cash support, reduction in indirect tax rates for selected sectors, employment scheme for the urban poor, higher infrastructure spending indirectly lifting demand, alongside direct aid to most affected sectors, including discretionary services. Limited bullets might, however, lower its effectiveness in boosting near-term demand.

Radhika Rao is chief India economist at DBS.

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