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

NEW DELHI: Within the Sixties, economists John Fleming and Robert Mundell developed a principle known as the Inconceivable Trinity, which claimed that no central financial institution can obtain three objectives on the identical time — a managed overseas change fee, free capital movement and an impartial financial coverage.

The Reserve Bank of India, which has been the establishment on the forefront of protecting the economic system from the Covid-19 pandemic, would in all probability be cognizant of this ‘trilemma’ greater than every other official physique within the nation.

Within the first week of August, RBI will element its subsequent financial coverage assertion. The central financial institution’s activity is minimize out.

Shopper worth inflation, which is RBI’s financial coverage anchor, has been uncomfortably past RBI’s goal of 2-6 per cent for 2 straight months now. Not solely has the medium-term goal of 4 per cent been breached, the value gauge has risen above the higher band of 6 per cent that the central financial institution has prescribed for itself.

From RBI’s aspect, the message is evident — inflation at this juncture is led by provide disruptions, and never demand components, and, due to this fact, financial coverage should stay accommodative so long as essential to rekindle financial development amid the Covid disaster.

Nonetheless, if the central financial institution is to fulfill its goal of 5.4 per cent CPI inflation in July-September, a rethink might must be on the playing cards.

The central financial institution has been recurrently infusing giant quantities of liquidity within the banking system since 2020 to make sure that borrowing prices stay low through the pandemic.

RBI’s pitch has been queered by the truth that the liquidity surplus has now swollen to shut to Rs 10 lakh crore, if one takes into consideration banking system liquidity and the federal government’s money steadiness.

At a time when inflation is uncomfortably excessive, sustaining such a surplus of liquidity brings with it the chance of asset worth bubbles and unrealistic valuations.

Actually, members of the Monetary Policy Committee have identified over the previous few months, asset costs are already stretched and unrealistic.

Fairness indices are close to lifetime highs regardless of the dismal development trajectory whereas the 10-year bond yield — the benchmark for pricing a gamut of credit score merchandise — has stubbornly hovered close to 6 per cent.

If not for RBI’s interventions, the reasonable pricing of the 10-year bond would have been near 7.50 per cent, given the availability and inflation metrics.


Over the previous few months, RBI’s coverage statements have had much less to do with financial coverage and extra to do with the sovereign debt market.

The query is no longer a lot about infusing liquidity, however extra about balancing the scales of demand and provide available in the market.

For the primary time ever, RBI has given an upfront dedication to develop its steadiness sheet and buy authorities bonds below a programme known as the ‘Authorities Securities Acquisition Programme’.

In earlier instances, RBI’s open market operations had been primarily geared toward infusing or draining out liquidity from the banking system. Now, nonetheless, the central financial institution, which can be the federal government’s debt supervisor, is trying to ease the burden of bond provide for the market and therefore anchor yields.

The flipside is that such operations result in a everlasting accretion of liquidity within the banking system. What complicates issues additional is RBI’s goal of sustaining the steadiness of the change fee amid heavy overseas institutional inflows via IPOs since final 12 months.

In its quest to sterilise the impression of its spot market interventions, RBI has needed to resort to important exercise within the ahead greenback market.

The central financial institution’s ahead greenback guide has now risen previous $50 billion because it goals to counterbalance its interventions within the spot market. This has resulted in a pointy rise in ahead greenback premiums, which basically represents the hedging value of long-term overseas buyers.

In a nutshell, RBI has to determine which section of the market deserves extra consideration. Withdrawing abruptly would spook markets and result in a spike in borrowing prices throughout the board, as was the case in January 2020 when RBI unexpectedly introduced variable fee reverse repo operations.

Letting liquidity rise much more, as is probably going due to large-scale Treasury invoice redemptions this quarter, would inflate asset costs much more.

And lest one forgets, the world’s largest economic system is now speaking about tightening rates of interest.

On August 6, the Indian central financial institution will announce its financial coverage assertion. Now, maybe greater than earlier, RBI is strolling a particularly tight rope. | Inflation: Excessive inflation & liquidity, bubble in asset costs: What can RBI do now?


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