India is one of the few countries that has technically entered into a recession even while its CPI inflation hovers at 7 per cent. It is ironic that, within the Consumer Price Index, prices of food and beverages have been hovering above 11 per cent for the last two months despite India having record levels of agricultural production in recent years.

Despite the lifting of the lockdown, and the government's ban on onion export, and facilitating import of certain essential commodities, prices of food items, including pulses, remain at an elevated level. Demand has improved considerably in the second quarter but the pricing power of firms remains low. Now, the hope is on last year’s high base effect for the CPI inflation to abate going forward. This shows that either the supply management is ineffective or demand management has gone overboard so as to push liquidity beyond what is required.

Essential commodities were allowed to move as freely as possible even during the lockdown. The rise in prices of onion, potato, and tomato is a seasonal or recurring phenomenon. How long will it take for India to improve its supply management of perishable commodities? Is it purely a seasonal phenomenon or is there an organised group of traders jacking up prices? Are the increase in the transportation cost and the levies on petroleum products the problem? A few ad hoc measures like an export ban may not be sufficient for effective supply management.

The disconnect

While inflation is an issue, there is a clear disconnect between the formulation of the monetary policy and its implementation. While the Monetary Policy Committee (MPC) is responsible for setting the policy rate, the implementation squarely falls on the RBI through day-to-day liquidity management. If there is a large divergence between the weighted average call money rate and the repo rate, then the MPC’s setting of the policy rate and the monetary policy implementation are not in sync.

Given the need for an accommodative monetary policy due to the Covid-induced stress, some excess liquidity in the system is desirable. However, it would be difficult to justify excess liquidity of around ₹6 trillion returning to the RBI daily via the reverse repo route.

Since the outbreak of Covid, the RBI has used both conventional and unconventional policy instruments to keep the economy from sinking. Unlike in western countries, India deployed unconventional monetary policy instruments much before reaching the zero lower bound of the policy rate. Do they work together efficiently?

Currently, the repo rate stands at 4 per cent after a cumulative cut of 115 basis points (bps) since February. The effective policy rate is well below the repo rate, and sometimes even below the reverse repo rate, which is 65 bps below the repo rate. The RBI has injected more than ₹11 trillion liquidity into the system through a reduction in the CRR, exempting the SLR, long-term repo operation (LTRO), targeted LTRO, open market operations, purchase of foreign exchange, special refinance facility for NHB, NABARD, Exim Bank, and liquidity facility for sectors like MSMEs/mutual funds/NBFCs.

If this much liquidity is needed and the effective policy rate is what the economy needs, why not cut the repo rate to the level of the effective policy rate?

Currently, all money market rates, even yield on short-term government bonds, are prevailing around the reverse repo rate.

Firms capable of issuing commercial paper and short-term debentures are benefited to meet their working capital requirement. The revival of investment, however, requires softer lending rate on an enduring basis.

Transmission of India’s policy rate to the lending rate has been modest, except for housing loans due to fiscal support and regulatory forbearances. Banks are reluctant to lend as the risk profile of borrowers has worsened with Covid, besides pre-existing weak balance sheet problems.

The 10-year benchmark sovereign bond yield remains around 190 bps above the repo rate despite the RBI pumping huge liquidity and pursuing switch operations - buying long bonds and selling short-term government papers. Benchmark yield is under pressure mainly due to unprecedented government borrowing, possibly beyond the capacity of India’s financial system. Ultra-accommodative fiscal policy that puts pressure on sovereign yield and comes into conflict with RBI’s low interest rate policy. Attracting FII investment in debt by maintaining interest rate differential is also not desirable.

The RBI has to staunch the excess liquidly going forward, leaving not more than ₹1 trillion in the system. This would partly prevent ‘irrational exuberance’ in the stock market. Since the current CPI inflation is dominated by supply side factors, the MPC can consider ignoring it.

As monetary policy is forward-looking and the RBI believes that inflation expectations are anchored, a further repo rate cut by 50 basis points in the next two policy cycles is desirable. Simultaneously, the government should refrain from additional borrowing as it would raise benchmark yield and defeat the very purpose of an accommodative monetary policy. Supply side factors causing inflation require focus.

The writer is a former Principal Advisor and Head of the Monetary Policy Department of RBI.