RBI, Don’t Shy Away From Doing The Right Thing

The December monetary policy review was, on the surface, an uneventful one. No rates were moved. No change in stance or voting patterns. Yet, it has led to a furious debate on whether to take the central bank’s words at face value or watch its actions.

The central bank’s commentary, particularly that of Governor Shaktikanta Das and Deputy Governor Michael Patra, suggested that it is sanguine about the upside risks to inflation. In contrast, its actions, some believe, are intended to actually tighten monetary policy by stealth.

Two questions arise here. First, if the strategy is to tighten by stealth, will it work? Second, why does the central bank need to use stealth?

Did RBI Really Tighten By Stealth?

The debate has been prompted by the RBI’s decision to move much of the daily liquidity absorption away from the fixed rate reverse repo window to the variable rate reverse repo window. A bit of context here. Under the RBI’s new liquidity framework, it was always the intention that the variable rate windows will become the primary tool of liquidity management and the reliance on fixed rate windows will reduce. So in some ways what the RBI is doing now is moving towards that new framework — a move that was delayed by the Covid-19 crisis.

But that’s not what has the market buzzing.

The assertion that most liquidity absorption will move to a variable rate window led one set of traders and economists to believe that the RBI had tightened by stealth.

The math here is that the weighted average rate of liquidity absorption would be pushed up to near the repo rate of 4% using this strategy, since cut-offs at the variable rate reverse repo auctions have been close to that level. As the weighted average rate of liquidity absorption moves higher, so would the call money rate, which is the rate at which banks borrow from each other. This call money rate remains the operating target for the RBI’s monetary policy and, hence, the RBI would have engineered a move up in the effective policy rate to close to the repo rate of 4%. Until recently, given the prevailing surplus liquidity conditions, the reverse repo rate of 3.35% was seen as the effective rate.

Others point to flaws in this argument.

The first is that the variable rate window is voluntary. While the RBI will raise the auction sizes at this window starting this month, banks can choose not to use it. Yes, logically, banks will drift towards the window which offers a higher rate but these auctions have sometimes been underutilised.

The second question raised by some is whether the RBI would need to do back-to-back shorter tenor VRRR auctions to really impact the overnight call money rate. If so, this would then lead to unnecessary volatility in the call money rates, which would run counter to the central bank’s objective to non-disruptive monetary policy normalisation. It is worth noting here that even as the VRRR cut-offs have risen, the call money rate has remained closer to the fixed reverse repo rate.

The third issue is that of distribution of liquidity. Since only banks can access the RBI’s liquidity windows, surplus liquidity will keep the tri-party repo rate, which is the rate relevant to non-bank participants like mutual funds, low.

The RBI itself gave no explanation of what broader objectives it was intending to meet, through its decision to move liquidity absorption to the variable rate window. So, it is entirely possible that the market is reading too much into the decision.

Why Does RBI Need To Act By Stealth?

The more important question to ask is why the RBI would need to act by stealth, if that is what they are doing.

Inflation is a legitimate concern. Headline inflation, even by RBI’s below-consensus projection, will remain at 5% even by middle of next year. Core inflation is at near 6%. As such, with a one-year ahead view, the central bank would be fully justified in normalising policy. Remember, normalising here does not necessarily mean a sharp rise in rates or a sudden withdrawal of liquidity. It simply means moving from ultra-accommodative policies to accommodative policies. At the December policy, for instance, all that was expected by a small 20 basis point hike in the reverse repo rate to move towards a normal interest rate corridor.

We must also mention here that the RBI’s November survey showed a surge in household inflation expectations. However, the central bank made an unusual call to do an “extension survey” after the government’s excise duty cut, which reflected lower expectations. The optics did not look good, and the central bank ought to stay away from anything that calls its intent into question.

From the outside, it looks like the RBI is trying to manage too many different narratives.

It does not want to be seen as tightening policy as growth recovers. But it also does not want to allow the easy policy to spur imbalances. It does not want an expectation of higher interest rates to take hold. But it also wants to project that it remains committed to its inflation target in letter and spirit.

If it was the Omicron scare that kept the RBI on hold before it moves ahead with more direct normalisation of policy, that is understandable. It could have said so in as many words, while guiding towards normalisation ahead. But if the RBI is trying to delay normalisation in the quest for what the governor called a “durable, strong and inclusive” recovery, it must remember that monetary policy has its limitations.

For the RBI, it is now time to rebalance its priorities, normalise and ensure the hard work of the last seven years on inflation control isn’t lost. That‘s the right thing to do and the RBI mustn’t shy away.

Ira Dugal is Executive Editor at BloombergQuint.