Can RBI afford to play a ‘T20 match’ in 2020? No

Amol Agrawal

The title of this article takes one to the shortened form of cricket Twenty- Twenty, or T20 as it is called popularly. So, should one expect a similar policy from the Reserve Bank of India (RBI) that is focussed on a short period?

Not at all as central banks typically play -- or are expected to play -- the test match, the longest form of the game.  In fact, it is more like a continuous series of test matches which requires lots of patience and dedication.

Just after winning a match – say, against inflation -- the central bank cannot really celebrate, but prepare for the next challenge. The test matches will test you in all possible ways: uncertainty, nature of wicket (read economy), rains -- both predicted and random -- shocks and surprises and so on.

Given this, what should one expect from the RBI in 2020 while continuing to play the test match? In 2019, the RBI eased policy rates by 135 bps in the five monetary policy meetings from February to October. Markets widely expected the central bank to ease policy rates in its December meeting, but it surprised by pausing and keeping rates unchanged.

It raised its inflation projections to 4.7-5.1 percent from 3.5-3.7 percent for H2 2019-20. The upward revision is due to rise in prices of vegetable and milk products, which is expected to continue in the next few months. More importantly, RBI’s household expectations surveys showed that more households expect inflation to rise over the one year horizon compared to previous surveys.

On the growth front, the RBI lowered projection for 2019-20 to 4.9-5 percent from 6.1 percent in the October policy. It had also cut growth projection from 6.9 percent in the August policy meeting.

This combination of lower growth and higher inflation -- also called stagflation -- is a dreaded scenario for most policymakers. The advent of stagflation in the 1970s led central banks to discard the Phillips Curve and attack inflation at the cost of pushing their economy to recession. The Phillips curve says the change in unemployment within an economy has a predictable effect on price inflation.

It is unlikely that India will face a stagflation as inflation is likely to come down, given inflation is low in most parts of the world. But you can never be sure. Post-2008 crisis, inflation was low in other countries, but not in India, and it took several attempts to push down inflation.

Thus, it will all depend on inflation trends, going forward.  With the inflation targeting mandate, the RBI cannot help but focus on inflation as it did in its December policy meet. The RBI expects inflation to remain above 4 percent till March 2020 and then gradually decline to 3.8-4 percent in H2 2019-20. Even if RBI’s Monetary Policy Committee (MPC) has said there is policy space for future action, the evolving inflation trends rule out a rate increase till April 2020 policy.

The other factor is the fiscal deficit position of the government, which is trying to keep it at 3.3 percent of GDP (gross domestic product) in 2019-20. First, most experts have said the actual fiscal deficit is much higher than reported numbers. Second, this year in particular, meeting the fiscal deficit target is unlikely to be met, given the shortfall in GST revenues due to both problems in the tax design and slowdown in the economy. Third, there is pressure on the government to push some form of fiscal stimulus to aid the economy.

All these factors will most likely result in a higher fiscal deficit and this will also weigh on the monetary policy next year. A higher deficit could push inflation even higher and press the RBI not to lower interest rates. In fact, if there is a fiscal stimulus, it will lessen pressure on the central bank to ease monetary policy.

Apart from interest rates, there have been suggestions that the RBI should do something different as interest rates have not really impacted markets. It cut policy rates by 135 bps in 2019, but the overall transmission has been weak.  In the December review, the RBI noted that “the weighted average lending rate (WALR) on fresh rupee loans sanctioned by banks declined by 44 basis points while the WALR on outstanding rupee loans increased by 2 basis points”.

During the media interaction that followed, one question was whether the RBI would press ahead with Operation Twist (OT). This implies that the central bank will sell short-term bonds and buy long-term ones to lower long-term interest rates, which will push down cost across loan markets, corporate bonds and the like. Taking a cue, RBI has initiated OT to lower long term interest rates (see my piece.)

Noted columnist Andy Mukherjee recently wrote that the Reserve Bank should do its own Quantitative Easing (QE), which implies buying bonds from banks/NBFCs (non-banking financial companies) which in turn will lower interest rates. Unlike OT, QE leads to expansion of central bank balance sheet. Economics Professor Sashi Sivramkrishna in his response pointed out that QE is nothing but a variant of MMT (Modern Monetary Theory), but is discredited by the mainstream economists.

RBI has already started to act outside the interest rate toolbox by doing OT. It is like sending a night watchman who has been effective so far as long-term bond yields have declined.

In the 2011 P R Brahmananda Memorial Lecture, noted economist Stanley Fischer remarked that in a crisis, central bankers often find themselves implementing policy actions that they never thought they would have to undertake.His advice to central bankers was “Never say never”.

As the RBI gets ready to play test match in 2020 on a tricky wicket, it will be handy to remember Fischer’s words.

Amol Agrawal is faculty at Ahmedabad University. Views are personal.