Monetary Policy Committee Notifications

Challenges ahead for the RBI

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Taper tantrum

Mains level : Paper 3- Challenges ahead for the RBI in withdrawing expansionary policy measures

With the Indian economy showing green shoots, RBI has to face some fundamental challenges while withdrawing the expansionary measures. The article discusses such challenges.

Expansionary policy as a response to pandemic

  • To manage the financial pressures unleashed by COVID-19, the RBI unleashed several measures.
  • It reduced policy interest rates aggressively.
  • It released an unprecedented amount of liquidity in the market.
  • It instituted a slew of measures for targeted assistance to, especially distressed sectors.

Time to roll back the expansionary monetary policy

  • As the Indian economy is showing the signs of recovery, the RBI must be planning for a non-disruptive exit out of the easy money regime.
  • Reversing a crisis-driven expansionary policy has to be a deliberative process, with the timing and sequencing carefully planned.
  • A big lesson of the global financial crisis is that any missteps on the exit path by way of commission, omission, or importantly communication, can be costly in macroeconomic terms.

Challenges RBI will face on the way out of expansionary monetary policy

1) Restraining inflation while supporting the recovery

  • Inflation remained above the RBI’s target band for the past several months.
  • According to the RBI’s own estimates, inflation is expected to remain above the band for the next several months.
  • Yet, the MPC, in its recent review, decided against any rate action out of concerns for growth and financial stability.
  • The MPC expects inflation to soften on its own in the weeks ahead.
  • That outcome is not inevitable.
  • Inflation could be pressured upwards by several factors even though there could be some apparent softening purely because of base effects.
  • There is the risk that persistent high inflation expectations would result in food inflation getting more generalised.
  • Core inflation could firm up because of rising input prices.
  • ‘Excessive margins’, among the factors cited by the MPC as one of the causes of high inflation, may not disappear.
  • Equally, there are concerns that the recovery, for all the positive signals, is still fragile. 
  • And there is heightened concern about an aggravated unemployment problem caused by big firms retrenching labour to cut costs.

2) Impact on savings

  • RBI should also be concerned about the plight of savers who are being shortchanged by low-interest rates at a time of high inflation.
  • Low-interest rates, its impact on inflation and economic recovery taken together make a complex cocktail of dilemmas for the RBI as it seeks to normalise the policy rates.

3) Withdraw excess liquidity at right time and to avoid ‘taper tantrum’

  • Another related challenge will be to withdraw the ‘excess’ liquidity in good time.
  • Banks are routinely depositing trillions of rupees with the RBI every day, evidencing that all the money that the central bank injected into the system is not doing much good anymore.
  • Every financial crisis can be traced back to mispricing of risk.
  • Mispricing of risk results when there is too much liquidity sloshing around the system for too long.
  • It will drive investors into dodgy ventures and threaten financial stability.
  • As the RBI seeks to guard financial stability by normalising liquidity, it will have to contend with possible market tantrums.
  • The lesson from the taper tantrums in the U.S. is that the RBI will have to manage its communication as carefully as it does the liquidity withdrawal.

4) Stability of the rupee

  • Next challenge for the RBI will be to restrain the rupee from appreciating out of line with fundamentals.
  • Here, the RBI is confronted with a classic case of ‘the impossible trinity’.
  • The impossible trinity deals with allowing free capital flows while simultaneously maintaining a stable exchange rate and restraining inflation.
  • The current account surplus this year together with massive capital flows has meant an excess of dollars in the system putting upward pressure on already overvalued rupee.
  • The RBI has absorbed nearly $90 billion this fiscal year to prevent exchange rate appreciation and to maintain the competitiveness of the rupee.
  • The RBI’s ability to continue to intervene in the forex market will be constrained by its anxiety about how the resultant liquidity might aggravate inflation and the risk to financial stability.

Consider the question “What are the challenges ahead for the RBI while winding down the expansionary monetary policy measures that were announced to deal with the economic disruption of caused due to pandemic and subsequent lockdown.

Conclusion

It is better to be rough right, as Keynes said, than be precisely wrong. That should be the guiding principle for RBI as it navigates its way out of the crisis driven easy money policy.


Back2Basics: What is taper tantrum?

  • Taper tantrum refers to the 2013 collective reactionary panic that triggered a spike in U.S. Treasury yields, after investors learned that the Federal Reserve was slowly putting the breaks on its quantitative easing (QE) program.
  • The Fed announced that it would be reducing the pace of its purchases of Treasury bonds, to reduce the amount of money it was feeding into the economy.
  • The ensuing rise in bond yields in reaction to the announcement was referred to as a taper tantrum in financial media.
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