Inflation: High Inflation & Liquidity, Asset Price Bubble: What Can the RBI Do Now?
The Reserve Bank of India, which has been the institution at the forefront of protecting the economy from the Covid-19 pandemic, would likely be more aware of this ‘trilemma’ than any other official body in the country.
During the first week of August, the RBI will detail its next monetary policy statement. The task of the central bank is cut out.
Consumer price inflation, which is the anchor of the RBI’s monetary policy, has been uncomfortably beyond the RBI’s target of 2 to 6 percent for two consecutive months now. Not only was the medium-term target of 4 percent exceeded, but the price indicator broke the upper 6 percent range that the central bank set itself.
From the RBI side, the message is clear: Inflation at this point is due to supply disruptions, not demand factors, and therefore monetary policy should remain accommodative for as long as needed to revive economic growth amid the Covid crisis.
However, if the central bank is to meet its target of 5.4% CPI inflation in July-September, an overhaul may need to be considered.
The central bank has regularly injected large amounts of liquidity into the banking system since 2020 to ensure that borrowing costs remain low during the pandemic.
RBI’s speech was troubled by the fact that excess liquidity has now swelled to nearly Rs 10 lakh crore, taking into account the liquidity of the banking system and the government’s cash balance.
In an age of uncomfortably high inflation, sustaining such excess liquidity carries the risk of asset price bubbles and unrealistic valuations.
In fact, members of the Monetary Policy Committee have pointed out in recent months, asset prices are already tight and unrealistic.
Equity indices are near life highs despite the dismal growth trajectory, while the yield on 10-year bonds – the benchmark for pricing a range of credit products – has stubbornly hovered around 6%.
Without RBI’s interventions, the realistic price of the 10-year bond would have been close to 7.50 percent, taking into account measures of supply and inflation.
WHAT CAN RBI DO?
In recent months, the RBI’s policy statements have less to do with monetary policy than with the sovereign debt market.
It is no longer so much a question of injecting liquidity as of balancing the scales of demand and supply in the market.
For the first time ever, RBI made an early commitment to expand its balance sheet and buy government bonds under a program called the “Government Securities Acquisition Program”.
In the past, the RBI’s open market operations were primarily aimed at injecting or draining liquidity from the banking system. Now, however, the central bank, which is also the government’s debt manager, is looking to ease the burden of supplying bonds to the market and therefore anchor yields.
The flip side is that such transactions lead to a permanent accumulation of liquidity in the banking system. Complicating matters further is the RBI’s goal of maintaining exchange rate stability amid large foreign institutional inflows via IPOs since last year.
In its quest to sterilize the impact of its interventions in the spot market, RBI has had to resort to significant activity in the dollar futures market.
The central bank’s dollar futures portfolio has now passed $ 50 billion in an attempt to offset its interventions in the spot market. This has resulted in a sharp rise in term premiums in dollars, which mainly represent the cost of hedging long-term foreign investors.
In a nutshell, RBI must decide which segment of the market deserves more attention. A sharp pullback would scare the markets and cause borrowing costs to skyrocket across the board, as happened in January 2020 when RBI unexpectedly announced floating rate reverse repurchase transactions.
Allowing liquidity to rise even more, as is likely the case due to massive Treasury bill redemptions this quarter, would inflate asset prices even further.
And let’s not forget, the world’s largest economy is now talking about tightening interest rates.
On August 6, India’s central bank will announce its monetary policy statement. Now, perhaps more than before, RBI is walking an extremely tight rope.