The RBI has signaled a return to normalcy

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There may have been a little shift in tone from RBI last Friday, but it is unquestionably the most meaningful in recent memory. The statement stated very little, but it was clear from reading between the lines that it signaled a shift in strategy. Governor has taken the second step toward normalization by deciding to drain some surplus liquidity; the first being the tolerance for higher rates at government paper auctions in July.

The calculated action—doubling the amount to be withdrawn to Rs 4 lakh crore—can not be criticised, and it is likely required, considering that the inflation estimate has been raised to 5.7%. That’s a good 20-30 basis points over consensus, and it’s also a smart strategy since it leaves the Monetary Policy Committee with less room for error. The bond markets have no cause to squabble any longer. The central bank has given them notice, stating unequivocally that it wants to begin soaking up liquidity as soon as possible. 

The central bank’s measures resulted in a small increase in bond yields; analysts now predict the benchmark to rise to about 6.4-6.5 percent by the end of the year; short-term paper is also likely to rise in price. As the largest borrower, the government will have to pay more; in FY21, it was able to borrow a record amount at the lowest possible rates. So far in FY22, the Centre has been frugal, perhaps fearful of rising borrowing rates.

The central bank, on the other hand, deserves great credit for the way it announced the shift. Although Deputy Governor’s argument for why the policy was not tightened despite inflation being well over the MPC’s comfort zone may not be academically sound, there is no disputing that these are tough times, and the RBI may be given some leeway. The argument that the central bank is concentrating on average inflation and that the glide path would see it move from 6.2% in FY21 to 5.7% this year and then to 4% in the next year is well received.

While the most recent round of the poll of respondents’ median inflation expectations for the three-month and one-year ahead periods revealed a hardening of 50 basis points and 60 basis points, respectively, between May % July. However, some believe that the central bank’s duty is to manage inflation rather than encourage growth; in fact, they say that the central bank can’t do much to boost aggregate demand, which necessitates fiscal stimulus. As a result, the current monetary policy is unjustified. 

That may be true, but at a time when the government is hesitant to relax its purse strings, and there’s a good possibility a third wave is on the way, it benefits if interest rates stay low for as long as possible. Despite the fact that the repo rates have been lowered, banks are only lending to the very best, not to those who truly need the money.

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