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Central Banks' Actions - Need for Caution

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December 22, 2018

What is the issue?

  • There has been a series of central bank actions across the world in the past few days.
  • The emerging trend in this regard needs appropriate attention and policy response.

What are the recent developments?

  • The Federal Open Market Committee (FOMC) of the US Federal Reserve went ahead a policy rate hike recently.
  • Across the Atlantic, the European Central Bank (ECB) has stated its intention to end its Quantitative Easing (QE) programme soon.
  • India’s central bank has announced an enhanced QE of its own from January, 2019.

How does the future look?

  • The Fed rate hike was the fourth in the calendar year 2018 and the ninth since December 2015.
  • But the US central bank now projects only two rate hikes in 2019 (as against three expected earlier).
  • It's because it sees US GDP growth rate easing even as inflation moderates.
  • The ECB will stop its QE, by which it has been buying €15 billion worth of bonds every month.
  • It has thus injected over €2.6 trillion in liquidity since March 2015.
  • The ECB will reinvest the proceeds of those bonds as they mature.
  • Also, there is Fed’s rate hike and ongoing steps of quantitative tightening.
  • Together, these imply a tighter liquidity scenario for hard currencies in 2019.
  • One likely consequence is lower foreign portfolio investor (FPI) commitments to emerging markets.
  • In particular, this could mean sales by foreign portfolio investors (FPI) of rupee debt holdings as well as equity outflows.

What is the case with India?

  • The Reserve Bank of India (RBI) has eased the liquidity conditions, but has held policy rates stable despite lower inflation figures.
  • From January 2019, the RBI intends to buy Rs 600 billion worth of bonds every month in open market operations (OMO), effectively injecting that much liquidity.
  • The current liquidity deficit in the Indian banking system is estimated at Rs 1.3 trillion.
  • The widening of the liquidity deficit can be attributed to the higher fund demand by corporates to meet the advance tax payment deadline of December 15.
  • [Advance tax/'pay as you earn tax' means income tax should be paid in advance instead of lump sum payment at year end.]
  • This could be exacerbated by higher government borrowings, with the fiscal deficit target already exceeded.
  • In this backdrop, the central bank will be under pressure to cut rates at the coming meetings.
  • The headline inflation rate is down well below the targeted 4% year-on-year trend of the consumer price index (CPI).
  • This is due to negative changes in the food basket (which contributes 46% of the CPI by weight) and moderating fuel prices.
  • So there’s a case for a policy rate cut.

What is the need for caution?

  • Despite the above, the RBI has to consider the fact that core inflation (excluding food and fuel) is high at about 5.75%.
  • It must also track the potential impact of rate changes on the rupee.
  • If the dollar and euro rates go up, as they will, and rupee rates go down, the rupee could experience another spell of weakness.
  • The dollar may strengthen and continue to put pressure on emerging market currencies in particular on account of the rate hike.
  • This will also affect investors looking at these markets as the currency risk increases.
  • Also, as OMO expansion indicates, there is already a liquidity deficit.
  • So by stimulating consumer demand, a lower rate could lead to an increase in the liquidity deficit, driven by further drain of resources.
  • Also, banks with stressed balance sheets may not be willing, or capable, of passing on rate cuts to commercial borrowers.
  • In all, the RBI must consider bond market conditions, rupee movements and changing inflation projections before it decides on rates.

 

Source: Business Standard

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