After decades of moderation and inflation under control, central banks now face the unfamiliar challenge of persistent above-target inflation. While the upswing in inflation has been synchronous across economies, the policy challenge is more glaring and difficult in advanced economies.
Unorthodox monetary policies have been the default option in advanced economies with expectations of lower interest rates as the determinant of financial market outcomes. In the absence of inflation, unorthodox policy options like unlimited asset purchases provided a backstop to markets. The surge in inflation could be explained by the lag effects of the massive stimulus measures introduced post-Covid and delayed unwinding of monetary policy measures.
With advanced economies facing the likelihood of entrenched inflation alongside a growth slowdown, policy objectives, operating instruments as well as issues like central bank accountability mechanisms, will potentially need to be relooked. Quantitative easing programmes have, in the past, reinforced looser monetary policy with rates at the lower bound. These have moved from the initial set of limited asset purchases (QE1 and QE2), moving on to unlimited purchases during the pandemic. Beyond the immediate stabilisation impact of large-scale asset purchases, the debate about its impact on financial market risk-taking could be analysed.
In the current cycle even as the Fed pivoted away from its transitory inflation narrative towards the end of CY21, asset purchases though, in reduced amounts, continued into the first quarter of CY22.
Changing dynamics
Given the changing dynamics, should the same have been wound down faster or curtailed midway? Also, should there be asymmetry in initiation and unwind of asset purchase programmes? Beyond the role of QE in creating potential asset pricing distortions, the sequencing of exit may need rethinking.
Alongside QE programmes, forward guidance on central bank actions have traditionally provided certainty to market participants. Forward guidance in both forms – conditional and unconditional – have been misconstrued as tying up the central bank’s hand.
With markets having positioned based on such guidance, rapid changes in incoming data that could lead to reassessment in policy stance, may constrain the ability of central banks to pivot, fearing disruptive market reaction. Perhaps central banks can provide guidance towards their end objective or policy goal, rather than specific policy actions.
The RBI has traditionally done Open Market Operations to infuse liquidity, with swings in liquidity determining the same. Though OMOs have a direct impact on yield curve, the stated objectives have been to manage liquidity. India’s experiment with direct QE has been minimal with the RBI’s version of QE named as Government Securities Acquisition Programme (GSAP 1) in April 2021. However, as inflation dynamics started to change and economic recovery started, the RBI curtailed the same.
OMO purchases have always been for sovereign securities. At the same time, specific frictions in other markets are managed through operations such as LTROs. Limiting liquidity operations under OMO only through short-term securities should be obvious to avoid potential distortion of yield curve signals.
The monetary policy statement continued to provide forward guidance on an accommodative stance, especially in the easing phase during Covid. The same has been discontinued with uncertainties in the tightening phase. Withdrawal of accommodation, with the objective of aligning inflation outcome first below the range and subsequently closer to the target, has been emphasised now.
The RBI’s central mandate supported by the amendments incorporating the MPC target provide a broader framework for market participants. A detailed assessment of the rationale guiding policy actions is amply understood through post-policy briefings and MPC minutes.
The requirement of explaining breach of the upper band of the inflation target range for three consecutive quarters enshrines accountability on the central bank. The test of the same and follow-up actions would be demonstrated in the future.
Liquidity operations
An area that deserves more focus and debate is liquidity operations. Liquidity management operations are required to ensure the operating target is aligned to MPC’s policy rate. Large deviations should be limited to specific exigencies and ideally be normalised quickly. This is important as other credit risk assets are priced over the risk-free rate-taking cues from the overnight operating rate.
The central bank being armed with market-based measures such as market stabilisation scheme (MSS) remains essential to deal with episodes of liquidity surges that could conflict with the operating policy stance as determined by the repo rate. The provision of SDF at best provides a technical floor, but requires the banking system to intermediate it.
Overall, as the global economy enters a new era of higher inflation with potentially lower trend line growth, there could be changes emerging, both in the technical settings as well as the overall operating framework of monetary policy operations.
Rajeev Radhakrishnan is CIO, Fixed Income, SBIMF