The RBI’s pause on benchmark rates on October 9 was accompanied by a decisively (and strong) dovish guidance. The decision was unanimous, with one dissent on the extended accommodative stance. The key takeaway was a slight shift towards being growth supportive as recent hardening in inflation was put to transient factors. The bond markets also received a hand through a host of liquidity measures — both for the Centre as well as (debut) state development loans — helping to cap risk-free yields.
The markets’ read of the three external members of the monetary policy committee (MPC) was that they are more of a neutral-to-dovish hue. Minutes of the October meeting will shed some light on individual leaning, but the undertones of the policy statement largely vindicates that belief.
Much of the policy easing expectations at this juncture, hinge on the inflation trajectory, which has hardened owing to cost-push and supply-side disruptions, along with few domestic idiosyncrasies. As the economy recovers and slack in demand conditions narrow, this might also impart price pressures. Nonetheless, at this juncture, priority has been given to anchoring rate and inflationary expectations, with an eye likely on the available policy room vis-à-vis price momentum.
Despite downward rigidity in the benchmark rates (even after factoring in modest cuts from here), policymakers will be keen to anchor rates at prevailing (low) levels for an extended period of time.
There are few means to arrive at this end. Firstly, like the post-global financial crisis phase, the central bank could opt to keep the policy rate on hold for an extended period of time (post-GFC was 2Q09 to February 2010), even if growth appears to gain traction partly due to base effects, focusing instead on the weak capacity utilisation, slack in the labour market and incomplete deleveraging process by key economic agents.
Secondly, the negative gap in demand conditions should allow liquidity to be kept in surplus, without worrying about consumption-led price pressures. This might be accompanied by more doses of cheap financing windows, as already is the case, and these might be attached to pre-conditions to incentivise lending to the real economy.
Next, show their hand in the bond markets to ensure that hard-fought transmission doesn’t reverse out. Markets had gotten ahead of themselves counting on the authorities’ implicit yield curve control but has seen limited follow-through. Part of this was already served in the October meeting, including doubling the size of the weekly OMO, easing HTM limits for banks, and as a first, special liquidity support for state development loans. We anticipate a smaller proportion of liquidity-neutral operation twists going forward, to prevent a reflexive action in short-term yields. The latter are closely mapped by private sector borrowing costs.
Talks of direct debt monetisation have surfaced, but the concern is that once open, the tap will be hard to shut. Part of the official resistance can also be traced back to the past when automatic monetisation was par the course, essentially making monetary policy submissive to the fiscal levers. This mechanism was gradually diluted, bolstered by the introduction of the FRBM rules as well as the central bank consolidating its objectives to inflation targeting.
Factoring in that the economy usually runs twin deficits — fiscal and current account — is also a less than ideal situation to consider asset purchases, given the extent of concurrent dissaving as well as associated macro implications. Hence, while markets pin their hope on direct intervention, we see low likelihood, instead tapping secondary market purchases. Communication and guidance might continue to emphasise that the bias is for policy to stay growth supportive. It will, nonetheless, be a fine balance to ensure that the need to anchor rates and keep conditions ease doesn’t stoke credit bubbles and distort risk premiums.
Radhika Rao is an economist with DBS Bank Singapore. Views are personal.
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