RBI monetary policy: The liquidity lever may prove to be better price tamer

2023-08-10 19:33:02

MUMBAI: Monetary policy — and interest rates — are near-synonymous. But going by the central bank’s surprise choice of price-taming instrument Thursday, they need not be so in the next few quarters.

Whenever monetary authorities wanted to influence price levels for goods and services, they resorted to the popular tool — interest rates that make money more expensive or affordable. If inflation climbs, they raise the interest rate to dampen demand, and if growth slows, they reduce the cost of funds to fuel demand.

With inflation in India soaring due to high vegetable prices, the Reserve Bank of India, going by the textbook, could have raised interest rates. But it did not do so. It expects the current high prices for vegetables to be temporary. But Governor Shaktikanta Das promised to act when high prices turn out to be persistent.

That means whenever the RBI moves next to put a lid on price pressure it would be an increase in the key repo rate, the rate at which it lends to banks. But there’s a slight twist that is emerging. “The recent spike in CPI inflation is expected to be short-lived going by past trends,” said Das.

“In such situations, we need to remain watchful and not resort to any knee-jerk reactions. And deployment of policy instruments is not just in terms of rate and stance but there are other ways of dealing with it. We have done our bit with regard to the incremental CRR today.”

Governor Das is signalling that tinkering with liquidity could gain more prominence in monetary policy decisions than interest rates. Historically, monetary transmission has been the RBI’s nemesis. For long, the central bank was hooked on the belief that liquidity deficit alone made its rate actions effective. But years of practice showed it was not. Subsequently, it bought into a neutral liquidity policy.Monetary transmission is still haunting the central bank. In a footnote to his speech, Das said the transmission in this 250 basis points tightening phase since May ’22 has been less effective than it was during the easing cycle of Feb ’19 to March ’22.This in a way indicates that liquidity could be a more effective tool when it comes to impacting the market than headline rates.

“Incremental CRR was considered necessary in the background of the liquidity overhang,” said Das. “We considered it desirable in the interest of price and financial stability. It will have an impact on the inflation situation also.”

As the year wears on, there is a possibility of inflation climbing further or remaining sticky. Interest rate increases may not be a tool of choice, but others such as bond purchases affect liquidity.

The nature of liquidity is such that it could swing from one extreme to another, but the prevailing conditions would determine how the policymaker handles it.

Some economists expect India’s liquidity to slip into deficit in the next few months from an average daily surplus of `1.8 lakh crore in July.

Festival season and the approaching state and general elections could lead to a rise in demand for cash leaving the banking system in deficit.

Even if the RBI’s monetary stance is withdrawal of accommodation due to inflationary pressures, it may have to resort to infusing liquidity in the system to avoid dislocation. Targeting inflation at 4% is paramount. It may be attempted more through liquidity measures than policy rates.

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