Policy withdrawal may prove untenable, says Indranil Pan of Yes Bank

The world has turned a full circle on policy making – both for the government and for the central bank.

In the pre-Great Financial Crisis 2008-09 (GFC) phase, the direction taken was to contain fiscal deficit by controlling spending while the central banks would strive to reduce intervention in the financial markets and allow them to attain equilibrium. Further, free trade as an engine of growth was the expressed mantra with economic policies turning attention towards boosting exports growth, exploring opportunities of optimal usage of domestic resources by opening up the boundaries to free goods trade and also capital flows.

The GFC of 2008-09 changed a lot of this. Central banks, especially in the developed world, stepped in with all sorts of policy measures – both direct and indirect. Their first task was to prevent financial markets from freezing and hence liquidity enhancing measures such as bond buying was put in place.

Action also had to be taken to save a few financial institutions. And, finally, central banks in some regions even had to drop their policy rates to the negative zone to try and push lending and boost economic activity. Governments also had to step in with an easy fiscal policy. The offshoot of low interest rates and high fiscal accommodation was an increase in debt across the world.

The struggle, especially for G4 central bankers in the post-GFC world was to achieve a certain level of inflation that can signal growth being on a sustainable path, but this largely eluded them. Even then, central bankers were gradually starting to come out of the super easy monetary policy.

But COVID-19 has once again put them on a back-foot. In the current context, we are in a situation where the world is clearly witnessing significant financial repression. Financial repression is in the form of excess liquidity that has been pushed into the market through bond buying programmes. Central banks are making an explicit attempt to keep interest rates low – Operation Twists, Bank of Japan (BoJ) targeting of the 10-year yield etc. In India too, the RBI has announced measures to keep a tight check on the 10-year yield that includes Open Market Operation, Operation Switch, G-SAP 1.0 and 2.0. Every indication is that these are likely to continue.

No doubt central bankers are once again debating about the timing of exiting the ultra-loose monetary policy. But this could prove to be extremely difficult. Note that the role of the government has assumed greater significance due to Covid-19, whereby the task for the fiscal is not only to push growth but also ensure that the negative effects of Covid-19 on the social front is minimalized.

Thus, the fiscal will probably have a role to play even in the near future years as we get a clearer perspective of the socio-economic damage out of COVID-19. In this atmosphere, as governments need to raise more money from the markets, the role of the central banker would be to ensure that these supplies are absorbed and the impact on the interest rates are low.

Central bankers would possibly have to take into stride a relatively higher inflation level for some time to come and may not be in a position to react to it. Importantly, interest rates might have to be sustained at levels lower than inflation levels – first to support the government to raise additional money at lower rates and also to ensure that the existing debt does not hurt. Higher inflation would mean that the value of debt becomes less in the future and hence does not become unsustainable. Data shows that the world debt as a proportion of GDP has now climbed to 360 percent of GDP compared to 320 percent in the pre-Covid-19 era.

As indicated earlier, the RBI faces a similar conundrum at this point. Central government's borrowing programme is at Rs 12 lakh crore plus Rs 1.58 lakh crore that it will borrow to compensate states for the compensation cess shortfall. The state governments together are also expected to borrow somewhere around Rs 7-8 lakh crore. That is a lot of supplies in the face of dwindling risk appetite of the investors, including the domestic banking sector.

Thus, the RBI will possibly have limited option but to continue with its strategy of buying government securities and attempt to keep interest rates from moving up significantly. This also means that the current huge dose of liquidity would broadly continue and the RBI will be patient with inflation. For now, the RBI is expected to gain comfort from a likely dip of inflation from the next reading (as per YES Bank models) to below the 6 percent mark. The RBI also assesses that the current retail inflation is more a supply-side phenomenon but the challenge will come when and if the demand side kicks in.