Planning an exit out of the easy money regime

ECONOMY/ GOVERNANCE

Topic: General Studies 3:

• Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.
• Monetary Policy of RBI

Planning an exit out of the easy money regime

Context: The Reserve Bank of India (RBI) embarked on an extraordinary expansionary policy to manage the financial pressures unleashed by COVID-19, some of which are:

• It slashed policy interest rates aggressively
• Flooded the market with an unprecedented amount of liquidity 
• Instituted a slew of measures for targeted assistance to especially distressed sectors.

As we sight springshoots in the economy, the RBI must be planning for a non-disruptive exit out of the easy money regime.

What are the challenges that the RBI will confront on the way out?

• It should be deliberative process: When the economy is in crisis, central banks go for expansionary policy often shedding their characteristic deliberation. In contrast, reversing a crisis-driven expansionary policy has to be a deliberative process, with the timing and sequencing carefully planned. 
• Learning from 2008 Financial Crisis: Indeed, one of the big lessons 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. The lesson from the taper tantrums of US is that the RBI will have to manage its communication as carefully as it does the liquidity withdrawal.
• Absorption capacity of system: Banks are routinely depositing trillions of rupees with the RBI every day, evidencing that all the money that the central bank unleashed into the system is not doing much good anymore
• Dangers of easy money to Financial Stability: Mispricing of risk is the result when there is too much liquidity sloshing around the system for too long. It will drive investors into dodgy ventures and threaten financial stability.
• Restrain the rupee from appreciating out of line with fundamentals: Here, the RBI is confronted with a classic case of ‘the impossible trinity’ — of keeping doors open for capital flows while simultaneously maintaining a stable exchange rate and restraining inflation. Maintaining a policy balance across all three conflicting objectives can be tricky.
• Policy dilemma for RBI: The biggest challenge for RBI while planning an exit strategy will be to manage the tension between restraining inflation and supporting the recovery. 
• Plight of Savers: Quite apart from the upside risks to inflation and downside risks to growth, the RBI should also be concerned about the plight of savers who are being shortchanged by low interest rates at a time of high inflation. All these concerns taken together make a complex cocktail of dilemmas for the RBI as it seeks to normalise the policy rates.

Dilemma for RBI between Inflation Vs Recovery

• Inflation above Target Band: Inflation remained above the RBI’s target band for the past several months, and according to the RBI’s own estimates, is expected to remain above the band for the next several months. 
• Recovery concern of RBI: Despite inflation concerns, the Monetary Policy Committee of RBI decided against any rate action out of concerns for growth and financial stability. 
• RBI’s expectation of Inflation Softening: The MPC expects inflation to soften on its own in the weeks ahead as supply chains, disrupted by the lockdown, normalise, and the bumper winter crop comes into the market.
• Concerns with RBI’s expectation of Inflation Softening: Excessive margins, among the factors cited by the MPC as one of the causes of high inflation, may not disappear if firms, regaining pricing power amid demand recovery, raise prices to mend their balance sheets.
• Risk of Inflation Persisting: 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.
• Recovery Concerns: Equally, there are concerns that the recovery, for all the positive signals, is still fragile. It has also been uneven and unequal, with large industries finding their foothold while small and medium enterprises and the entire informal sector continue to be in distress. 

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.

Connecting the dots:

• The problem with liquidity push: Click here