‘The central bank is behind the curve’. This is a rather flippant statement made often when commenting on monetary policy. Can this be true? The standard argument given is that with the
With The Federal Reserve increasing rates and the Bank of England already in the increasing mode, the RBI should also be doing so because if they do not, then the institution is behind the curve. Is there merit to this argument?
The answer is no because the curve is how we define it. Central banks take decisions depending on what the mandate is. If the Fed is increasing rates, it is because it has a 2% inflation number to guard and as the price increase is above 7%, there is a compelling reason to start tightening the system. If we look inwards, the RBI has a mandate of defending an inflation rate in the region of 4-6%. As long as we are in this band, there is no question of being behind the curve by not doing anything. Even a single month's ugly inflation number does not warrant such an action.
Besides, often one mistakes ‘policy rate action’ for being the ultimate goal because this is what is overtly announced and rings in the mind. But if we look at RBI action, there has been enough done to give a signal that rates will be going up without actually saying much. The G-SAPs have been terminated and the VRRR has been made active with the SDF finally taking over for the overnight surpluses. Effectively, the banks are getting close to the repo rate return for their surplus balances.
Therefore, the central bank is definitely not behind the curve as it is not supposed to stun the markets but prepare players for the future as the surfeit of liquidity provided in the last two years, as well as ultra-low rates, need to be handled in a calibrated manner.
But what of the market? The market has been thinking differently because the concerns go beyond the repo rate. The bond yields have been rising ever since the war erupted and the present difference between the repo rate and the 10-year yield is 310-320 bps which is at an all-time high. In fact, this difference has increased ever since the repo rate was brought down to 5.15% in March 2020 and then to 4%. The spread between the 10-year bond and repo rate has hovered between 155- 310 bps. Does this indicate then, that the market is ahead of the curve?
This is interesting because if one looks back over the last decade, there have been different trends in the spreads of the market yields from the repo rate. In 2012, for example, the repo rate was at a peak at 8.5% after which it has been coming down. At a repo rate of 8-8.5%, the 10-year spread was extremely low at around 10-20 bps and also being negative at times. When the repo rate ranged between 7-8%, the spread was volatile between 10-110 bps and this was the period of 2013-September 2015. The repo rate has trended downwards subsequently right till the start of the pandemic. During this phase between September 2015 and March 2020, the spread was between 57 bps and 137 bps while the repo rate came down from 7.25% to 5.40%, with the lower spread going with a higher repo rate.
The picture since then has been in the upward direction with the spread now crossing 300 bps. There does, hence, appear to be a disconnection between the repo rate and the bond yields ever since the easy money policy was preserved during the lockdown. When the repo rate is at a high level, the bond yield spreads tend to shrink. But when the repo rate is at a low level, the spreads would be higher. An important takeaway here is that the market actually fairly prices government debt, and even if the policy rate is kept low, consciously as a decision of the MPC, the government will have to pay a higher cost for raising money in the market. To this extent, the repo rate may not be meaningful from the market point of view though at the institutional level still is critical.
The repo rate becomes critical for banks as it gets linked with the deposit rates and finally the lending rates through the MCLR. Banks too have started raising their rates before the repo rate goes up as the cost of deposits has changed for some of them thus leading to this chain reaction.
Therefore in June, we may have a situation where the MPC will have to adjust the repo rate to the market and bank rates, rather than the other way round. A twist in the tale?
(The author is Chief Economist, Bank of Baroda, and author of Lockdown or Economic Destruction? Views are personal)
