Why bond yields rose post RBI’s policy meet
Premium- RBI’s main goal since 2020 has been to ensure low rates to help the government borrow
- RBI plans to tackle inflation through withdrawal of ultra-accommodation to keep rates low
Government bond yields, or the return investors can earn if they hold bonds until maturity, typically don’t move much on a daily basis. Nonetheless, on Friday, they rose by 21 basis points (bps) and crossed 7% to close at 7.12%. One basis point is one hundredth of a percentage.
This jump came after the Reserve Bank of India (RBI) kept the repo rate, or the rate at which the RBI lends to banks, unchanged at 4% in its latest monetary policy. The RBI has been following an accommodative monetary policy to keep rates low to help the government, businesses, and individuals to borrow. There has been no change on this front.
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As such, it is surprising that the bond market wants a higher return from government bonds. “In the sequence of priorities, we have now put inflation before growth," said RBI governor Shaktikanta Das. Till now, Das had said inflation is transitory. However, RBI’s forecast for inflation for this fiscal has been increased to 5.7% from 4.5% earlier, a jump of 120 bps. According to its agreement with the Centre, the RBI needs to maintain an inflation target of 4%, with lower and upper tolerance levels of 2% and 6%, respectively. Inflation has been higher than 5% for much of the January 2020 to February 2022 period. Thus, inflation hasn’t been transitory.
Much of this inflation has been driven by supply-side factors. Nonetheless, core retail inflation, which leaves out the prices of food and fuel products on which the RBI has no control, has been higher than 5.5% for most of the time since mid-2020. Further, wholesale inflation has been greater than 10% from April 2021, forcing companies to raise prices. Commodity prices globally have risen further since the outbreak of the Russia-Ukraine war. This will keep feeding into retail and food inflation, which isn’t good news.
Despite this, the RBI has managed to meet the inflation target because the average inflation wasn’t more than the upper tolerance level of 6% for three consecutive quarters. At the same time it is worth remembering that over the medium term, the inflation target of 4% is something that the monetary policy needs to return the economy to.
The RBI is also the government’s debt manager. Its main goal since 2020 has been to ensure low rates to help the government borrow. This it has done by printing and pumping money into the financial system and driving down interest rates. The cost of this has been borne by those who save. Inflation has been higher than interest on bank deposits for most of the period since early 2020. Lower rates might encourage borrowing but also hurt those who save and earn lower interest, and that impacts consumption negatively.
On Friday, the RBI acknowledged that inflation has become a problem because of the war in Ukraine. It plans to tackle this through the withdrawal of ultra-accommodation, or the money it had printed, to keep rates low. The excess liquidity in the system as of 7 April stood at a whopping ₹7.7 trillion. This came as a surprise to the bond market, which was betting on the RBI continuing to help the government borrow at low rates. With less money going around, interest rates will go up. Also, the inflation forecast for the first two quarters of this fiscal stands at 6.3% and 5.8% respectively, meaning that the RBI is more than likely to hike the repo rate. The bond market is already discounting this possibility and that explains why bond yields have crossed 7%.
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Finally, if the idea is to tackle inflation, why does monetary policy continue to be accommodative? The RBI is clearly not in a hurry to admit that it was slow when it comes to tackling inflation.
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