High inflation & liquidity, bubble in asset prices: What can RBI do now?

NEW DELHI: In the 1960s, economists John Fleming and Robert Mundell developed a theory referred to as the Impossible Trinity, which claimed that no central bank can achieve three goals at the same time — a managed foreign exchange rate, free capital flow and an independent monetary policy.

The Reserve Bank of India, which has been the institution at the forefront of shielding the economy from the Covid-19 pandemic, would probably be cognizant of this ‘trilemma’ more than any other official body in the country.

In the first week of August, RBI will detail its next monetary policy statement. The central bank’s task is cut out.

Consumer price inflation, which is RBI’s monetary policy anchor, has been uncomfortably beyond RBI’s target of 2-6 per cent for two straight months now. Not only has the medium-term target of 4 per cent been breached, the price gauge has risen above the upper band of 6 per cent that the central bank has prescribed for itself.

From RBI’s side, the message is clear — inflation at this juncture is led by supply disruptions, and not demand factors, and, therefore, monetary policy must remain accommodative as long as necessary to rekindle economic growth amid the Covid crisis.

However, if the central bank is to meet its target of 5.4 per cent CPI inflation in July-September, a rethink may have to be on the cards.

The central bank has been regularly infusing large amounts of liquidity in the banking system since 2020 to ensure that borrowing costs remain low during the pandemic.

RBI’s pitch has been queered by the fact that the liquidity surplus has now swollen to close to Rs 10 lakh crore, if one takes into account banking system liquidity and the government’s cash balance.

At a time when inflation is uncomfortably high, maintaining such a surplus of liquidity brings with it the risk of asset price bubbles and unrealistic valuations.

In fact, members of the Monetary Policy Committee have pointed out over the last few months, asset prices are already stretched and unrealistic.

Equity indices are near lifetime highs despite the dismal growth trajectory while the 10-year bond yield — the benchmark for pricing a gamut of credit products — has stubbornly hovered near 6 per cent.

If not for RBI’s interventions, the realistic pricing of the 10-year bond would have been close to 7.50 per cent, given the supply and inflation metrics.


Over the last few months, RBI’s policy statements have had less to do with monetary policy and more to do with the sovereign debt market.

The question is now not so much about infusing liquidity, but more about balancing the scales of demand and supply in the market.

For the first time ever, RBI has given an upfront commitment to expand its balance sheet and purchase government bonds under a programme called the ‘Government Securities Acquisition Programme’.

In earlier times, RBI’s open market operations were primarily aimed at infusing or draining out 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 bond supply for the market and hence anchor yields.

The flipside is that such operations lead to a permanent accretion of liquidity in the banking system. What complicates matters further is RBI’s aim of maintaining the stability of the exchange rate amid heavy foreign institutional inflows through IPOs since last year.

In its quest to sterilise the impact of its spot market interventions, RBI has had to resort to significant activity in the forward dollar market.

The central bank’s forward dollar book has now risen past $50 billion as it aims to counterbalance its interventions in the spot market. This has resulted in a sharp rise in forward dollar premiums, which essentially represents the hedging cost of long-term foreign investors.

In a nutshell, RBI has to decide which segment of the market merits more attention. Withdrawing abruptly would spook markets and lead to a spike in borrowing costs across the board, as was the case in January 2020 when RBI unexpectedly announced variable rate reverse repo operations.

Letting liquidity rise even more, as is likely because of large-scale Treasury bill redemptions this quarter, would inflate asset prices even more.

And lest one forgets, the world’s largest economy is now talking about tightening interest rates.

On August 6, the Indian central bank will announce its monetary policy statement. Now, perhaps more than earlier, RBI is walking an extremely tight rope.

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