Money policy making in a K-shaped world to ensure an orderly evolution

Sometimes, no news is good news. With financial markets trading at rich valuations under post-Covid policy support, there are concerns that someday when growth normalizes, the punch bowl may be taken away. However, for now, economic recovery is lagging well behind buoyant financial markets.

The weakness in growth amidst Covid-led lockdowns prompted MPC to acknowledge that the current situation warranted “policy support from all sides – fiscal, monetary and sectoral”. RBI’s Monetary Policy Committee (MPC), therefore, left the benchmark rates unchanged and decided to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis.

As per the MPC, impact on growth owing to the second wave is expected to be moderate compared with the first wave. However, it is still enough to trigger a downward revision of 100 bps (to 9.5%) to MPC’s FY22 GDP growth projection.

Going ahead, progress in vaccination should lend support to a more durable recovery, while domestic inflationary pressures should somewhat moderate as supply-related logistic costs soften with easing of restrictions. A normal monsoon along with government’s measures to counter price increases should keep the overall risks to inflation broadly balanced.

Coming to markets, RBI has been nudging and guiding financial markets throughout the pandemic via its actions and communications to ensure an orderly market conditions. Bond markets are guided by RBI’s preference for “orderly evolution of yield curve”.

Hence, in addition to announcing the final tranche of Rs 400 billion under GSAP 1.0, the MPC has extended the G-sec acquisition program into Q2 with overall purchases of Rs 1.2 trillion under GSAP 2.0. RBI has extended its guidance to the currency and equity markets as well: while it has been intervening in the currency market when needed to reduce undue volatility, it has also warned about the risks emanating from stretched equity valuations in its recent publications.

Tools like GSAP are greatly innovative and much needed in addition to RBI’s continued guidance because market’s ability to absorb large government borrowings remains constrained. In other words, intent may not necessarily translate into ability without support.

In Alice in Wonderland, the Red Queen tells Alice that she has to run as fast as she can just to stay where she is. In today’s financial markets too, central banks are fast reaching a point where they may have to continue buying bonds in order to keep yields where they are. Markets have, in part, become used to this support over last one year. Weaning markets away from this support may prove be a little tricky in the medium term.

The MPC, however, for now has administered just the right dosage of stimulus to the markets and the economy. In time, as the benefits of the stimulus seep in, the MPC may look to adjust the dosage in accordance with evolving situation. With learnings from the past, the MPC should provide adequate forward guidance and prepare the markets for such gradual, non-disruptive fine-tuning of the stimulus. Keeping market conditions orderly when deviating from status quo will be the next big test of policy making going forward. Till then, it’s the status quo, yet again.

(Churchil Bhatt is EVP, Debt Investments at Kotak Mahindra Life Insurance. Views are his own)