India's Monetary Policy Committee and the Reserve Bank of India face tough choices when they meet this week.
Normalisation of the reverse repo rate, currently at 3.35%, is overdue but any signal that the RBI is speeding up its exit from ultra-accommodative monetary policy could push up bond yields further. Yields have risen sharply since the start of the year, with the government's nearly Rs 15 lakh crore gross borrowing plan adding to the pressure.
Should that prompt the RBI to stay on hold longer? Economists believe the central bank should continue down the path of normalisation and slowly shift its focus back to inflation, as fiscal policy remains focused on the uneven growth recovery. Narrowing the interest rate corridor by raising the reverse repo rate is also important to reduce volatility in money market rates, they say. Meanwhile, any upward pressure on long term rates will have to be handled deftly via other instruments at the RBI's disposal.
Edited comments based on conversations with BloombergQuint:
RBI Will Have To Be A Skilled Trapeze Artist: Sajjid Chinoy, JP Morgan
The RBI will have to be like a very skilled trapeze artist.
You have to recognise that fiscal policy is contracting not expanding. It is withdrawing stimulus, not adding to it. But it is withdrawing it more slowly if you go from 6.6% (which is where the fiscal deficit for FY22 may settle) to 6.4%. Now, given that fiscal policy is more accommodative, as it should be, monetary policy, which was reinforcing fiscal policy, will now have to become a substitute to more accommodative fiscal policy. If for no other reason, then because inflation has been sticky between 5-6%. More worryingly, inflation expectations, whether you look at households or businesses, have gone up. So, the current calibration of real policy rates staying at -150 basis points may not be appropriate, given the stance of fiscal policy, given where oil prices are, and given where inflation expectations are.
The way one should think about monetary policy is that exceptional measures were required during the pandemic. Now, we are exiting the pandemic and fiscal policy continues to be supportive, so monetary (policy) has to now slowly go back to its job of anchoring inflation and inflation expectations.
What this means is that short term rates may have to go up. But, if one believes that this will lead to long term rates going up as well, monetary policy has many instruments to deal with that. What the RBI will not want to do is increase its balance sheet or do quantitative easing in a year when major central banks are doing quantitative tightening and reducing their balance sheets.
There are many ways to get around this. If, for example, they raise short rates in the coming months, one way to ensure that long rates don't come unhinged is to do 'Operation Twist', where you buy long end bonds and sell short end bonds. The other way is to buy long end bonds and do forex swaps. Third could be that if your balance of payments is in deficit, you can sell dollars and absorb liquidity. What all of this does is it doesn't change the size of the balance sheet, it just changes its composition.
So, there are ways to accomplish both objectives — tighten monetary policy as inflation warrants, and then use other tools tactically to ensure long end doesn't get unhinged.
More broadly, central banks look at the Taylor rule, which builds in an inflation gap and an output gap. In the first two years of the pandemic, you said that the output gap is so large, let me focus on that. But in the third year of the pandemic, you have to re-balance away from output gap towards inflation, specially since fiscal policy is working to address the unequal recovery.
Sajjid Chinoy is chief India economist at JP Morgan.
RBI's Task Is Extremely Challenging: Sonal Varma, Nomura
The RBI's task is extremely challenging.
The demand-supply dynamics in the bond market look quite worrisome, if you look at the net supply of government bonds, and net out of the open market operation bond purchases the RBI has done of nearly Rs 2 lakh crore in the last couple of years. This is a large net supply hitting the markets at a time when global bond index inclusion is still a question mark. As such, the RBI is going to face a challenge. They would not want long term bond yields to go up too much because that has an impact on longer term growth. But even the ability to do something like an 'Operation Twist', where they sell short term bonds and buy long term bonds, is going to be limited, now that they have done a debt switch with the government.
But I don't think the budget should be changing the monetary policy normalisation path at all. When you are in a pandemic and you have an uneven growth impact, it is extremely important for fiscal policy to do targeted support and push on longer term goals. The role of monetary policy at this stage is extremely limited in terms of providing relief to those at the lower end of the income spectrum. There are risks that come from ultra-accommodative conditions and from tolerating higher inflation.
So far, we've had both monetary and fiscal policy focusing on growth. But going forward, as the government focuses on growth and rightly so in an uneven recovery, monetary policy should focus on financial stability. Inflation has been high, cost pressures are building up, core inflation is elevated, expectations are high, current account and fiscal deficits high. All those factors suggest normalisation should happen and should have happened by now.
In fact, by not moving the reverse repo and leaving the corridor so wide, it is leading to too much uncertainty. It will be better for markets if this uncertainty is out of the way and we start on the normalisation schedule so that there is a greater macro stability down the line which is crucial to attain growth.
A reverse repo rate hike should have happened in December. Perhaps, it is the signalling angle which is holding them back or the Omicron driven uncertainty may have held them back. But markets are very well prepared for it. The global dynamics, expected rate hikes from the Federal Reserve, oil, domestic inflation, domestic fiscal, and just to reduce volatility calls for a fixed rate reverse repo hike and a normalisation of the corridor. We are expecting it to happen in February and April.
Sonal Varma is chief economist - India and Asia ex-Japan at Nomura.
Normalisation May Get Pushed Back: Pranjul Bhandari, HSBC
The RBI was gearing up for gradual normalisation of monetary policy. Now, it may move a bit slowly because it may worry that the bond market is already under stress. What the budget may have done, by announcing such a large gross borrowing, is made the RBI a little unsure about its steps. My worry is that everything will get pushed back.
Before the budget, I was looking at a 20 basis point hike in the reverse repo rate in the February meeting, but now the risk is that they will push it out to the next meeting.
I think this is a problem right now because at a time when global central banks are tightening, investors are likely to become more selective. Coming across as a country where tightening is getting delayed may not be the right signal to send.
The best strategy is to raise the reverse repo rate by 20 basis points as it is completely priced in to the market. In addition, you also give the right signals that you have acknowledged inflation. But my worry is that for all the same reasons that the reverse repo rate was not hiked in December, it may not be hiked in February either. Omicron is a reason and, if there is stress in the bond market, that could become an added reason.
For now, it seems like the RBI is okay with the weighted average rate of absorbing liquidity going up by 20-30 basis points but it doesn't want to be seen as tinkering with any of the policy rates just yet.
There is a difference between what they should do and what they may do.
Pranjul Bhandari is chief India economist at HSBC.
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