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Photo: Mint

Two big riddles that RBI may still need to crack

The central bank’s GDP forecast seems realistic and its monetary policy sensible. But it may yet need to work out if its inflation target needs revision and bond market strategy a rejig

Our central bank expects India’s economy to get back into expansion mode only in the fourth quarter of 2020-21, a year that is projected to see a 9.5% contraction in output overall. This seems like a realistic expectation, just as the call taken by its reconstituted monetary policy committee (MPC) on Friday to leave its main policy rate at 4% was sensible. With retail inflation hovering above the Reserve Bank of India’s (RBI’s) tolerance limit of 6% and its real repo rate negative, further easing was out of the question. Yet, its focus was squarely on a growth recovery as we try to put the ravages of covid behind us. This was evident in RBI’s plan for liquidity infusion of another 1 trillion via “targeted long-term repo operations" (TLTRO), which would let banks cheaply borrow longer-term funds from it against top-rated securities. In addition, it said it would buy bonds issued by states and made home loans even more affordable. With commercial activity picking up and consumer confidence bouncing back from the depths it had plumbed, RBI saw both supply and demand in better sync, which may be why it termed inflation transient. If prices are indeed in control by the fourth quarter, as it expects, then its MPC could breathe easy. However, the outlook on those variables seems hazier than we would like, and so policymakers may have to confront two riddles. One: Does our inflation-targeting regime need greater flexibility? Two: Should RBI recalibrate its bond market dealings for better control of India’s yield curve?

Whether we need to relax our inflation target might depend on the Centre’s stimulus 2.0, if and when it materializes. Investment remains depressed, credit demand is low and lenders are risk averse. Given all the corona flux, extra money could yet stoke prices instead of production, or even distort asset values. The TLTRO package aims to put money in the hands of lenders for lending to specific sectors, but big sums being parked overnight with RBI by banks would suggest weak loan disbursals. If the government steps in with a burst of spending to spur our economy, then the MPC could struggle to keep inflation capped. While dumping our current framework would be bad for the long term, perhaps an escape hatch could be worked out for severe crises. Like the US Federal Reserve, RBI could adopt an average target to fight economic contractions.

India’s bond market, where the risk of negative returns on debt had frayed some nerves, responded well to both RBI’s moves and Governor Shaktikanta Das’s effort to talk prices up. On Friday, yields dropped across the yield curve stretching from low-tenure to 10-year debt, reducing the cost of capital a bit. RBI had said it would double its open-market bond purchases. The central bank’s goal has been to contain yields at the long end, which had crept up on fears of future inflation. Using “twist" operations, RBI has been buying long-dated paper and selling short tenures. Critics of its interventions, however, have pointed out glaring gaps in the mid-range of our yield curve, even as investors show signs of resistance to yield repression. Rather than persist with the same game and exhort all players to play ball, RBI may need to re-adjust its bond buying and selling in a way that balances market forces better with the Centre’s expanded borrowing plan. It would be a big help, of course, if we had a clear picture of the government’s revised budget this year.

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