2 min read.Updated: 09 Oct 2020, 01:32 PM ISTLivemint
The central bank’s GDP forecast seems realistically optimistic and its monetary policy sensibly growth oriented. But it may still need to work out whether its inflation target needs revision and its bond market strategy a rethink
India’s central bank expects our economy to get back into expansion mode in the fourth quarter of 2020-21, a year that’s 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 unchanged at 4% is sensible. With retail inflation above the Reserve Bank of India’s (RBI’s) tolerance limit of 6% and its real policy rate negative, further easing was out of the question. Yet, its focus is clearly on a growth recovery as we try to put the ravages of covid behind us. This is evident in its liquidity infusion effort via another ₹1 trillion package of “targeted long-term repo operations" (TLTRO), which would let banks cheaply borrow longer-term funds from it against top-rated securities. It has also said it will buy state bonds, which is welcome. In addition, it has eased rules on home loans, which is likely to make them even more affordable. Its consumer confidence survey has pointed to a revival from the depths it had plunged to, which would be good for demand in general, and it foresees an easing of inflationary pressures ahead, which would grant it some space for manoeuvre later. If prices are in control by the fourth quarter, as RBI expects, then it would justify its current stance. So far, so good. However, it still faces two big challenges on which the outlook seems hazy. One: Does its inflation targeting regime need greater flexibility? Two: Should it recalibrate its bond market operations for better control of the yield curve?
Whether India needs to relax its inflation target would depend on the Centre’s stimulus 2.0, if and when it materializes. Investment remains depressed, credit demand low and lenders risk averse, so extra money being made available could stoke prices rather than production, or even end up distorting 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 credit activity. If the government steps in with a burst of spending to spur our economy, then the central bank’s MPC may find itself sweating to keep inflation down. While dumping the current framework would be a bad idea for the long term, perhaps an escape clause could be worked out for severe crises. Like the US Federal Reserve, RBI could adopt an average target in case of an economic contraction.
India’s bond market responded well on Friday to RBI’s announcements, with yields dropping across the yield curve stretching from low-tenure to 10-year debt. The cost of capital thus stands slightly reduced. Apart from opening a TLTRO window, RBI said it would double its open-market bond purchases. The central bank’s general objective here has been to keep down yields at the long end, which have crept as fears of future inflation dampen demand for 10-year bonds. Via its “twist" operations, RBI has been buying long-dated paper and selling short tenures. Critics of its debt management, however, have pointed out glaring gaps in the yield curve’s mid range and signs of resistance from investors to its moves to flatten it. Rather than persist with the same twists, RBI may need to re-adjust its bond interventions to balance market forces better with the Centre’s borrowing plan. It would help, of course, if we had true clarity on the latter.