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.
