RBI’s tight financial push is justified

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The RBI has largely done its job under difficult circumstances. By my assessment, it has gone through about three quarters of the magnitude of the current rate hike cycle, but the economy is stronger than before.

This belies the misconception that if RBI starts raising rates, the nascent pandemic recovery will be nipped in the bud. The RBI has demonstrated its ability to act on both sides of the economic cycle. It may have been a little slow to start normalizing, but it almost made up for it.

After finishing my term at the MPC, I had publicly stated that the final rate in this tightening cycle could be 6.5%, although RBI may become data dependent after raising the key rate to 6.0%. The cycle is generally moving in this direction. It is heartening to see RBI losing its panache for forward guidance that limited policy flexibility. However, the third consecutive rate hike of 50 bps at the end of September after a first of 40 bps did not surprise or disturb the market.

Forward guidance may have played a useful role at the start of the pandemic, but it has long since lost its usefulness. If RBI had, in that late-September policy, hinted at anything about the terminal (maximum) key rate in this cycle or when it would continue to raise rates, it would only have tied itself to the at a time when global uncertainty is extremely high, and responsive agility is needed to maintain macro-financial stability.

Appropriate rate hike

In my view, the MPC got the right quantum of rate hike. Turning to smaller rate hikes would have been premature at this stage and would have misled the markets in addition to having a negative impact on the credibility of the central bank. The economy is quite strong and inflation remains well above target.

The RBI still has work to do to bring inflation back into the target range to first soft-land the economy and then bring it very close to the 4% one-off target over a two-year period so that the gains from inflation targeting in anchoring expectations are not lost and higher medium to long-term growth is achieved through a stable environment.

The only dissent within the MPC on the amount of the rate hike is therefore not very significant. Although a certain slowdown in the economy is anticipated in the future, four elements must be taken into consideration.

First, the RBI still has some catching up to do as real deposit rates are still negative and may further contribute to widening the current account (CAD) deficit which is reflected in the savings-investment gap. . Unless the economy slows markedly in the coming quarters, the CAD/GDP ratio is expected to be around 3.4% this year, significantly higher than the central bank’s guidance below CAD 3.0%. The central bank may be talking about reducing currency pressures, but even at 3.0% the CAD is unsustainable and therefore rate hikes are helpful.

Second, the RBI does not need to match the Fed’s 1:1 rate hike quantum because inflation is a bigger issue in the US relative to the inflation target. Yet, if the RBI keeps rates at this level, it could entrench high inflation.

Third, a reluctance to raise rates would contribute to financial fragilities with poor asset valuations. Fourth, it is important to understand that monetary policy cannot work without sacrificing growth, even though from a political economy perspective, central banks struggle to say so in their communication.

The quantum of the end-September rate hike can go a long way towards achieving the economy’s disinflation target – as monetary transmission gains traction with the sharp rate hike that occurs for the first time after the system moved away from large excesses of liquidity.

Banks have been unduly reluctant to raise deposit rates while the pass-through has been more on the lending side, mainly due to large excess liquidity. Their net interest margins were protected to the detriment of savers. Against a rate hike of 140 basis points since May this year before the last hike, the weighted average lending rate to outstanding rupee loans rose by 41 basis points, while weighted average rates term deposits on national rupee deposits in circulation increased by only 26 basis points.

Considering the RBI’s projected average inflation rate of 6.7%, the weighted average real rate on the loan side stands at 2.43% (1.63% for fresh rupee loans which increased by 82 basis points in this up cycle), while that on the deposit side remains at (-) 1.41% (see chart).

Cash management

While the RBI in its post-policy communication has sought to allay liquidity fears by explaining that liquidity is not too tight, the fact is that without government balances, the liquidity of the system that sets money market rates is temporarily in balance. Yet, the sustainable excess liquidity which includes government cash balance was 3.69 lakh crore on the eve of the last policy.

Once the festival currency leaks and other FX interventions take place, the liquidity of the sustainable system may tighten further and may hover below ₹1 lakh crore.

Should the central bank worry too much about these tighter liquidity levels? Why should it do this when in fact it will force banks to raise deposit rates and accelerate the transmission to positive real rates at which monetary policy can be considered neutral and not yet tight in a literal sense?

At a time when we are facing the double whammy of high inflation and spillover from exchange rate pressures, even mildly deficit liquidity conditions will be justified as they will ease both of these pressures.

Will this lead to a destabilizing spike in interest rates? No, unless the government deviates from the path of fiscal consolidation as election cycle considerations come to light. The government has so far done well in exercising restraint while taking supply-side measures to reduce inflationary pressures.

(to be concluded)

The author is a professor holding the IEPF chair at the NCAER. He was previously an executive director of RBI and a member of the MPC. Views are personal

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