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Home >Opinion >Views >RBI’s treacherous path to policy normalization

Central banks tend to work in ways that seem oblique and abstruse to many people. Typically, a central bank has three channels through which it hopes to transmit desired changes to markets, firms and households. The first is direct: changing interest rates or liquidity in the economic system. The second is through signalling (broadly, via minor policy shifts or indirect action), which, while avoiding the nuclear button of direct action, allows it to get the message across to targeted economic agents. The third is communicating to markets, an art form that has evolved from former Federal Reserve chairman Alan Greenspan’s riddles and mumbles at one end of the spectrum, to his successor Ben Bernanke’s explicit messaging at the other. “Ambiguity has its uses, but mostly in non-cooperative games like poker," Bernanke is believed to have said, “Policy is a cooperative game." The Reserve Bank of India (RBI) has also had its share of variations. Raghuram Rajan would often attract the ire of ruling party politicians by speaking out, while his successor Urjit Patel’s taciturn approach dismayed markets. Current governor Shaktikanta Das walks a median line, even bringing his bureaucratic metier to the mix.

This context is important for us to understand RBI’s Friday noises about a phased resumption of its normal liquidity management operations—which had been warped by the pandemic—with a variable rate, 14-day reverse-repo auction of bonds worth 2 trillion scheduled for 15 January. The distinct message is that as the economy gets back to normal, so should its liquidity management operations. But there’s more than meets the eye. Alarm bells must have started ringing on Mint Street after overnight lending rates dropped below RBI’s reverse-repo rate of 3.35%. The central bank cannot be faulted for wanting to soak up some money and nudge rates back into its 3.35-4% corridor. View this through another lens: while RBI’s monetary policy committee has control over the repo rate, the one at which banks can borrow from the central bank, the governor has control over the reverse-repo rate, what RBI pays on deposits that lenders park with it. Over the past 12 months, as RBI drove rates down and kept systemic liquidity high to kick-start growth, the repo rate lost its significance and the reverse-repo rate became our operating rate. With overnight rates going below even reverse-repo rates, neither the MPC nor RBI seem to have a handle on the market. This could be the final straw.

There are other causes for RBI concern. The continuing overhang of excess systemic liquidity, estimated at around 8 trillion, has depressed interest rates in the short-term, but also threatens to ignite inflationary fires in the medium-to-long term. Food prices show no sign of relenting, with pressures now washing up from overseas, too. In addition, nozzle-head prices for petrol and diesel are at stratospheric levels. This raises apprehensions of another kind: a rising price line amid falling or negative real interest rates over extended periods could adversely affect savings, allow excessive leverage, and result in asset mispricing. This then offers fertile ground for financial crises, which RBI can ill-afford now. Its dilemma is unique: tasked with inducing growth impulses, RBI must also anchor inflationary expectations. This will require our governor to walk a tightrope. It might also be time for RBI to sharpen its communication strategy because it will need markets on its side in the months ahead.

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