Interest rates

With inflation looming, Shaktikanta Das is getting its way on interest rates in 2022. But is it a good long-term move?

With India still in denial about its looming inflation problem in February, analysts at Nomura Holdings Inc. ranked the options available to the monetary authority into three categories. First, they claimed there was a 15% chance that the central bank was right to ignore supply-side pressures.

But their base case, which they gave a 50% chance of happening, was that the Reserve Bank of India was wrong and that he should focus on price stability. However, they explored a third alternative, which they estimated to have a 35% chance of occurring: that the RBI, being wrong about inflation, simply tolerate it.

In a Feb. 25 report, Nomura analysts Sonal Varma and Aurodeep Nandi wrote, “This is a fiscal dominance scenario, in which policy rates rise significantly less than we expect in 2022, but Macroeconomic risks – both inflationary and external – could be significantly greater than our current baseline. “We believe this scenario could lead to stagflation.”

Fiscal dominance occurs when government finances – for example, the cost of borrowing – take over and force the monetary authority’s hand over interest rates, limiting the monetary authority’s ability to fight against inflation. This is not the case in India at the moment. India’s central bank stunned the market with an unplanned 40 basis point hike in the benchmark interest rate in early May, when the fiction of short-lived inflation became impossible to track.

inflation

It continued Wednesday by raising the policy rate by 50 basis points, although the tightening was widely anticipated this time. For now, it does not appear that the fiscal authority is in a rush to prevent the central bank from finishing its job.

The annual rate of price increase hit an eight-year high of 7.8% and continues to rise. In other words, India’s fight against inflation is still in its infancy. The Ministry of Finance could lose its temper if the RBI raises bond yields too much to contain price pressures, complicating the government’s plan to raise funds by selling a record 14.31 trillion rupees ($184 billion). dollars) of tickets this year.

Is RBI really concerned about inflation?

Prime Minister Narendra Modi’s administration appears unfazed so far. New Delhi announced a $26 billion package, including fuel tax cuts, to help the RBI tame inflation.

inflation

The annual rate of price increase hit an eight-year high of 7.8% and continues to rise. In other words, India’s fight against inflation is still in its infancy. The Ministry of Finance could lose its temper if the RBI raises bond yields too much to contain price pressures, complicating the government’s plan to raise funds by selling a record 14.31 trillion rupees ($184 billion). dollars) of tickets this year.

After Rajan decided to return to the University of Chicago in 2016, there was a schism between him and his replacement. Governor Urjit Patel has faced questions on everything from interest rates, which a monetary policy committee is now setting, to his handling of growing corporate debt and, finally, whether the RBI has more capital than she didn’t need it. Patel’s deputy has been ridiculed for advising the government against plundering RBI funds.

Following Patel’s unexpected resignation in December 2018, Das, a former finance ministry official who oversaw the implementation of Modi’s tough currency ban in late 2016, took over. When such collaboration became the norm globally during the pandemic, a new era of peaceful coexistence between fiscal and monetary authorities began.

However, now that the pandemic has passed, other points of contention have emerged. The central bank and the Ministry of Finance may be singing the same hymn sheet regarding rating hikes. Yet the RBI’s capital issue is heating up, thanks to the lowest dividend the ministry has secured in a decade: just under $4 billion, a third of last year’s payout.

Even this lower payment was made possible by the central bank simultaneously selling $97 billion in foreign exchange reserves and buying $114 billion in the spot market. Ignore purchases. Each dollar sold is valued at its historical weighted average acquisition cost. Since this figure is lower than the current exchange rate, exchanging dollars for around 78 rupees today results in profit sharing with New Delhi. According to Observatory Group analyst Ananth Narayan, without this “active conversion of revaluation gains into realized profits”, the RBI would have needed a net injection of capital from the government.

According to Narayan, the RBI’s capital requirement has been reduced due to the shrinking balance sheet, and the dividend has not been reduced to zero. If central bank assets do not increase this year, it could put a tussle over whether to give money to the government or tap it to have funding suspended again.

inflation

This could be the case, given that there is almost no inflow of dollars into India at the moment, only outflows. Nevertheless, according to Narayan’s calculations, the economic capital of the RBI, which has already fallen below the minimum of 20.8% in assets set by a 2019 committee, is an unnecessary constraint. This would not have happened if the Ministry of Finance had not already coveted the capital of the RBI. Having to depend on politicians for money is undesirable for an organization that must protect its autonomy to be credible in its fight against inflation.

Due to India’s precarious public finances, the threat of fiscal dominance over monetary policy is ever-present. This is not a significant problem because inflation is an unexpected increase in tax collection. However, as Nomura’s Nandi points out, monetary tightening is still “far from the finish line”. Das slashed rates in a surprise stimulus package just two months after going official, ahead of Modi’s re-election in May 2019.

It was then. It would be fascinating to see if the RBI chairman can amuse his political masters now that the cycle has changed. Or if, like his two predecessors, his relations with the administration will begin to deteriorate.

Edited by Prakriti Arora