🤔 RBI’s Inflation Control Plans in Jeopardy?
The RBI is finally in the mood to control inflation now but the government of India has other plans.
Our economy is in such a state right now that the moment we solve one problem another springs up.
For months we had been struggling with inflation. And last week the RBI took the first step toward solving this problem.
In a surprise move, the central bank raised interest rates last week to control a 17-month high inflation rate of 6.95% (you can read more about that decision here).
But now a request by the government may derail its plans to control the liquidity (amount of cash) in the economy.
💸 More Money, More Problems
Having too much money doesn’t really seem like a problem to you and me, but for the economy, this could be a very bad thing.
You see, our economic system is such that everything needs to be in perfect balance.
Too much money leads to inflation (because a lot of money is chasing the same amount of goods causing their prices to go up), meanwhile, too little money reduces investments and hampers growth.
So, central banks like the RBI always have to be on their toes to ensure that the economy has just the right amount of liquidity.
They do this by increasing or decreasing the interest rate at which banks borrow money from it. If interest rates are low, there is higher liquidity as borrowing is easier. On the other hand, borrowing becomes difficult when interest rates are high and so liquidity decreases.
And when Covid hit, the RBI did its job. It lowered interest rates so borrowing money would be easier and growth wouldn’t stop even in such trying times.
But this led to inflation.
Nobody was surprised at this outcome.
But the real problem began when the RBI didn’t readjust the interest rate when inflation started gaining speed.
It wanted to support growth as much as it could.
These best-laid plans are now having the opposite impact, just because the RBI messed up the timing a little.
How?
👀 It's Complicated
The high inflation has also caused India’s bond yields to soar to 7.29%.
That’s because bonds are typically low-interest instruments as compared to equities or other riskier assets.
So, during times of high inflation people don’t really invest in them as returns are almost negligible.
For instance, the current real return on bonds would be return- inflation, which is 7.29%-6.95%= 0.34%
So, fewer people are investing in bonds and this increases bond yields.
Huh?
You see, a 5% interest rate on the face value of Rs. 100 wala bond will always give you Rs. 5 as interest every year, regardless of its price. But say the price of the bond in the market becomes Rs. 90 due to reduced demand. You can effectively buy a Rs. 90 bond to get Rs. 5 interest, which is technically said to be a “yield” of Rs. 5 / Rs. 90 = 5.55%).
That’s how yields are rising right now. And this is problematic.
Because as yields of bonds increase, the borrowing cost for the companies gets higher (more people start parking money in bonds).
For many companies, this could be disastrous and lead to a decline in growth and valuation.
This could further give way to recession and unemployment.
The government obviously doesn’t like this.
So, it has asked the RBI to buy back bonds from the markets to reduce yields.
How will that help?
Well, if the bank buys back bonds, demand for bonds will increase and prices will rise, lowering yields.
But this is counterproductive to RBI’s current strategy of removing liquidity from the market.
You see, if the RBI buys back bonds from the market, it will inject a large amount of cash. This will further fuel inflation and the vicious cycle will continue.
So, what can the RBI do now?
Well, it does have a few other tools in its kitty to combat this problem.
For instance, it could conduct special open market operations (basically the trading of bonds in the open market).
In these open market operations, it has the option to buy short-term bonds from the market in exchange for long-term bonds.
This will increase the price of short-term bonds and reduce yields, plus no extra money will be added to the economy.
Though this does create problems for the future, those can be managed.
Something else that the RBI can also do is refuse to accept the high bond yields. Huh?
You see, when the government borrows money from the market, it is the RBI that decides whether or not to accept the prices being offered by the buyers.
If it believes prices are too low (making the yields too high) it can refuse to sell the bonds.
In such a scenario underwriters of the bonds (basically primary banks and financial institutions) have to step in and buy the government bonds.
There is another simple solution that the RBI can take.
So far, buying government bonds was a hassle for retail investors (here’s why).
But the RBI has introduced a new scheme that has made this process easier.
If it works towards further popularising this scheme, it could solve the bond liquidity issue once and for all.
Now, it remains to be seen which of these steps the RBI will take and what will be its consequences.
⚡ In a line: The government wants the RBI to buy bonds to reduce yields but this could jeopardise the bank’s plan to reduce money in the market.
💡 Quick question: Will the RBI be able to tackle inflation and boost growth at the same time?
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